Global Investment Strategy Weekly Report, “Seven Structural Reasons for a Lower Neutral Rate in the U.S.,” Dated March 13, 2015, Available at Gis.Bcaresearch.Com

GLOBAL INVESTMENT STRATEGY

WEEKLY REPORT Edge RESEARCH DISCOVERY ACTION What Happened To The Growth The interface of investment research May 22, 2015 Periodical Dividend From Lower Oil Prices?

In this Issue: CHART 1 FF Market Overview: FF The boost to global growth from Unlike In The Euro Area, Bond Selloff It’s All About The falling oil prices has been smaller In U.S. Not Driven By Liftoff Expectations... Terminal Rate...... 1 Months Months than most anticipated. FF Focus Section: MONTHS TO HIKE*: The Underwhelming FF Public anxiety that gasoline prices U.S. Economic Response 50 EURO AREA 50 To Lower Oil Prices.....3 will rise again, a higher willing- FF What Does This Mean ness to save the windfall from For Investors?...... 11 lower oil prices, a larger-than- expected hit to energy capex, 40 40 worries that falling oil prices will

exacerbate deflationary pressures, 30 30 and higher fuel taxes have all re- strained aggregate demand. 20 20 FF In addition, higher heating bills owing to the cold winter in the

U.S., along with a jump in health 10 10 care spending, appear to have eaten up about 40% of the gains © BCA Research 2015 from lower oil prices. JAN APR JUL OCT JAN APR JUL 2014 2015 FF * NUMBER OF MONTHS TO FIRST RATE HIKE, AS DISCOUNTED IN THE Concerns about the environmental OVERNIGHT INDEX SWAP CURVE. SERIES SHOWN SMOOTHED EXCEPT consequences of increased oil FOR LATEST DATAPOINT. production may limit the supply- Editorial Board side benefits of lower crude Market Overview: Peter Berezin prices. It’s All About The Terminal Rate Managing Editor FF The recent run-up in Treasury ne of the recurrent themes of this publi- Mathieu Savary Senior Editor yields will ultimately be reversed. cation has been the idea that the precise Investors should expect the dollar O Jim Mylonas timing of the liftoff date for the fed funds Editor/Strategist to strengthen modestly against the rate is a less important driver of long-term Melanie Kermadjian euro, but more so against the cur- Senior Analyst rencies of oil-exporting economies bond yields than how high rates ultimately Isabelle Ng such as Brazil and Russia. go. The past few weeks have reinforced this Research Analyst view. Chart 1 shows that unlike in the euro

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CHART 2 CHART 3 …But Rate Expectations Household Deleveraging: Further Out Are Rising No Longer The Main Culprit %%% Of % Of GDP U.S. PRIVATE NONFINANCIAL DEBT GDP

U.S. FED FUNDS RATE 170 170 3.2 3.2

165 165

2.4 2.4 160 160

155 155

1.6 1.6 150 150

MARKET EXPECTATIONS*: CURRENT 145 145 APRIL 17, 2015 .8 JANUARY 30, 2015 .8

% Of % Of GDP CONSUMER CREDIT* GDP 18.5 18.5 0 © BCA Research 2015 0 2014 2016 2018 2020 2022 2024 * BASED ON OVERNIGHT INDEX SWAPS.

18.0 18.0 area, “months to hike” in the U.S. has barely budged. What has changed is the terminal rate, 17.5 17.5 which has risen by 60 basis points since April 17 (Chart 2).

17.0 17.0 Many pundits have argued that despite the recent selloff, bond yields are still unnaturally low, supported only by the Fed’s printing press. 16.5 16.5 However, this reasoning reveals a fatal conceit. © BCA Research 2015

The fed funds rate has been close to zero for 04 06 08 10 12 14 * INCLUDES AUTO LOANS, CREDIT CARDS, STUDENT LOANS, AND OTHER seven years now, yet growth has remained ane- NON-HOUSING RELATED FORMS OF CONSUMER CREDIT. SOURCE: FEDERAL RESERVE BANK OF NEW YORK. mic and inflation has been dormant. One can no longer blame the deleveraging cycle. Chart 3 shows that private nonfinancial debt has been flat as a share of GDP since 2012 while consumer credit has actually been rising.

Admittedly, fiscal restraint and the sluggish recovery in home construction have weighed on growth. As government spending returns to normal and housing starts rebound, the Fed will be able to dial back monetary stimulus. Yet, it is highly unlikely that the Fed will be able to restore rates anywhere close to pre-crisis levels. In part, this is because a variety of structural factors – ranging from slower

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The Fed will potential growth, the shift to a capital-lite econ- CHART 4 Increased Supply Has Accounted For The need to keep omy, higher income inequality, and the lack of 1 Bulk Of The Drop In Oil Prices Since October real rates a major asset bubble – will restrain spending. %5 lower than It is also because a stronger dollar will curb 0 they would domestic demand. It is critical to note that otherwise be while the impact of a stronger dollar on infla- -5 to offset the tion is temporary, the impact on the level of -10 loss in de- real GDP is permanent. This, in turn, implies

that the Fed will need to keep real rates lower -15 CUMULATIVE CHANGE IN OIL mand from a PRICES* FROM JULY 2014 TO larger trade than they would otherwise be to offset the loss OCTOBER 2014 EXPLAINED BY: in demand from a larger trade deficit. -20 SUPPLY (3.7%) deficit. DEMAND (96.3%) Six months ago one might have hoped that the -25 JUL AUG SEP OCT decline in oil prices would compensate for a 2014 stronger dollar. However, as we discuss in this 10% week’s focus section, while we expect the eco- 0 nomic benefits from lower oil prices to become

more apparent in the months ahead, the overall -10 impact appears to be smaller than anticipated. -20

CUMULATIVE CHANGE IN OIL Focus Section: -30 PRICES* FROM OCTOBER 2014 The Underwhelming Economic TO JANUARY 2015 EXPLAINED BY: -40 SUPPLY (58%) Response To Lower Oil Prices DEMAND (42%) © BCA Research 2015 As oil prices began to swoon last autumn, many -50 OCT NOV DEC JAN observers predicted that the global economy 2014 2015 would receive a substantial growth dividend. * USING LOG OF DAILY PRICES. NOTE: MODEL ASSUMES A POSITIVE DEMAND SHOCK IS ASSOCIATED WITH AN INCREASE IN BOTH STOCK PRICES AND OIL PRICES, WHILE A The rationale was straightforward: unlike in POSITIVE SUPPLY SHOCK IS ASSOCIATED WITH A DECREASE IN OIL PRICES AND AN INCREASE IN STOCK PRICES. 2008, the drop in oil prices since last October SOURCE: IMF WORLD ECONOMIC OUTLOOK (APRIL 2015). largely reflected increased oil supply rather than weaker demand, a point that the IMF documented in its most recent World Economic Outlook (Chart 4). Conceptually, increased oil production should expand the global economy’s productive capacity, helping to lift growth. At the same time, since the marginal propensity to spend tends to be higher for oil consumers than for producers, a shift in disposable income towards the former should have raised overall global aggregate demand.

Of course, we do not know what would have happened in the counterfactual scenario where Saudi Arabia chose to cut production in order to keep prices elevated. However, given that consensus

1 Please see Global Investment Strategy Weekly Report, “Seven Structural Reasons For A Lower Neutral Rate In The U.S.,” dated March 13, 2015, available at gis.bcaresearch.com.

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Discover CHART 5 CHART 6 Global Growth Estimates Households Have Saved what you Have Been Pared Back Much Of The Oil Windfall %%US$/ % can do BLOOMBERG CONSENSUS U.S. 4.8 4.8 Bbl with BCA GDP GROWTH FORECAST: WTI* OIL PRICE (LS) 2014 SAVING RATE (PERCENT OF 5.8 110 Analytics. 4.0 2015 4.0 DISPOSABLE INCOME) (RS) 2016 3.2 3.2 100 GLOBAL 2.4 2.4 5.4

%% EURO AREA 90 1.6 1.6

80 5.0 1.2 1.2

.8 .8 70

%% U.S. 4.6 3.0 3.0 60

2.6 2.6

2.2 2.2 50 4.2

1.8 1.8 © BCA Research 2015

%%JAN APR JUL OCT JAN APR JAPAN 2.0 2.0 2014 2015 * WEST TEXAS INTERMEDIATE. 1.5 1.5 1.0 1.0 .5 .5 global growth estimates have fallen steadily

%%over the past six months, it does seem that the payoff from lower oil prices has not been 2.8 U.K. 2.8 as great as many had hoped (Chart 5). 2.4 2.4 2.0 2.0 We see seven reasons why this has been the 1.6 1.6 case: %%BRICs* 7 7 Reason 1: Households Expect Much 6 6 Of The Decline In Oil Prices To Be 5 5 Reversed Basic economic theory posits that people %%CHINA tend to save temporary increases in income. 8.0 8.0 The rise in the personal saving rate since 7.6 7.6 November suggests that households do not 7.2 7.2 6.8 6.8 expect the windfall from lower gasoline prices © BCA Research 2015 to last (Chart 6). Survey data confirm this 2013 2014 2015 * INCLUDES BRAZIL, RUSSIA, INDIA, AND CHINA.

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Households in CHART 7 CHART 8 Skeptical Global Consumers Oil Futures: Changing Characteristics countries that US$/ US$/ WHAT DO YOU THINK WILL HAPPEN TO THE PRICE Bbl Bbl experienced OF A GALLON OF GAS IN YOUR AREA BY SUMMER? 110 WTI FUTURES CURVE*: 110 large credit PRICES WILL INCREASE JUNE 21, 2014 PRICES WILL STAY THE SAME CURRENT booms in the MARCH 31, 2015 PRICES WILL DECREASE 100 100 past remain U.S. (JAN 15) reluctant to 76 14 10 90 90 spend more even if they U.S. (MAR 15) 80 80 have the 84 10 5 wherewithal 70 70 to do so. U.K. 70 20 9

60 60 GERMANY 77 17 6 50 50 © BCA Research 2015 © BCA Research 2015

0 20 40 60 80 100 14 15 16 17 18 19 20 (PERCENT) * WEST TEXAS INTERMEDIATE. SOURCE: BLOOMBERG. NOTE: SURVEY BASED ON RESPONDENTS WHO OWN A CAR OR LIVE WITH SOMEONE WHO OWNS A CAR. SOURCE: BART VAN ARK AND WILLEM OVERMEER, “GETTING A HANDLE ON ENERGY: GLOBAL GROWTH SCENARIOS IN TIMES OF CHANGING OIL PRICES,” THE CONFERENCE BOARD, APRIL 2015.

hypothesis. Chart 7 shows that the vast majority of households who own a car in the U.S., U.K., and Germany expect gasoline prices to rise by this summer.

This perception is broadly shared by the market, as evidenced by the fact that the oil futures curve has gone from backwardation to contango over the past seven months (Chart 8). Despite the rally in spot prices since March, investors still expect WTI prices to rise another $8 over the next five years. Back in June, they expected long-dated prices to fall by $21.

Reason 2: Things May Be Different In A Post-Debt Supercycle World Even among those who think that gasoline prices will stay low, many appear to have decided to save their additional disposal income. According to a recent survey by The Conference Board, only 20% of Americans expect to spend the windfall from lower oil prices.2 Interestingly, the fraction of respondents who said they planned to use the windfall to boost savings or pay back debt was noticeably higher in the U.S. and U.K. than in Germany (Chart 9). This suggests that households in countries that experienced large credit booms in the past remain reluctant to spend more even if they have the wherewithal to do so.

2 Bart van Ark and Willem Overmeer, “Getting A Handle On Energy: Global Growth Scenarios In Times Of Changing Oil Prices,” The Conference Board, April 2015.

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Discover Reason 3: Oil Capex Has Become More CHART 9 Credit Bubbles Leave Deep Scars what you Sensitive To Price Fluctuations HOW HAS THE RECENT DECLINE IN GAS PRICES can do Until the shale revolution began, most energy IMPACTED YOUR FINANCIAL DECISIONS? with BCA projects had long lifecycles. It normally takes SPENDING THE SAVINGS ON OTHER THINGS seven to nine years before the discovery of a SAVING MORE / REDUCING DEBT WITH THE SAVINGS Analytics. INVESTING IN FINANCIAL deep sea oil field yields any output. However, PRODUCTS WITH SAVINGS NO IMPACT once the oil is flowing, the producer can expect to generate revenue for another 20 to 30 years. U.S. (JAN 15) In contrast, a typical shale well can be drilled 20 32 3 45 in under one month, but will see 80% of its reserves depleted within two years. U.S. (MAR 15) 20 23 3 54 This makes shale producers a lot more nimble, allowing them to cut capital spending quickly in U.K. the face of lower prices. This is precisely what 21 18 3 58 has happened recently: investment in mining structures declined at a 48% annualized rate GERMANY in Q1, slicing 0.52 percentage points off U.S. 23 9 5 64 GDP growth. © BCA Research 2015 0 20 40 60 80 100 (PERCENT)

Reason 4: Inflation Was Already Too Low NOTE: SURVEY BASED ON RESPONDENTS WHO OWN A CAR OR LIVE WITH SOMEONE WHO OWNS A CAR. SOURCE: BART VAN ARK AND WILLEM OVERMEER, “GETTING A HANDLE Before The Oil Crash ON ENERGY: GLOBAL GROWTH SCENARIOS IN TIMES OF CHANGING OIL PRICES,” THE CONFERENCE BOARD, APRIL 2015. In the past, the economic benefits from falling oil prices were typically amplified by interest rate cuts made possible by declining inflation. This time around, inflation was already uncomfort- ably low in most developed economies, while monetary policy was hamstrung by the zero bound constraint. Chart 10 shows that unlike in previous episodes, the decline in inflation expectations that accompanied the drop in oil prices led to an increase in real rates, which helped undercut the beneficial impact on economic activity.

Reason 5: Blame The Tree Huggers The discovery of easily accessible petroleum resources in the late 19th century helped usher in the automobile age while also making possible the creation of brand new industries based on pet- rochemicals.

A defining feature of that era was that the cost of oil not only fell dramatically, but its usage expanded by several orders of magnitude. In the current setting, however, while the price of oil has dropped, environmental concerns are likely to limit how much crude actually makes it to the market. This, along with the fact that developed economies have become a lot less oil intensive over the years, will limit the supply-side benefits from the shale revolution Chart( 11).

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Two-thirds of In fact, the copious amount of investment that CHART 10 all declared has already taken place in the oil sector over the Zero Bound And Low Inflation past decade could turn out to be a key source Minimize Tailwind global US$/ % Bbl U.S. of economic and financial risks. The Interna- WTI* OIL PRICE (LS) energy -1.3 tional Energy Agency reckons that two-thirds 110 REAL** FED FUNDS RATE (RS) reserves of all declared global energy reserves could be could be made obsolete if a deal is reached to limit the -1.4 made increase in the planet’s temperature to 2°C 90 obsolete if by the end of the century.3 Kepler Cheuvreux, a deal is a consultancy firm, estimates that this could -1.5 70 reached to leave nearly $30 trillion in stranded energy limit the assets, equivalent to 40% of current global -1.6 4 increase in GDP. High-cost producers such as Canada and 50 the planet’s Brazil would be most affected (Chart 12). So grave are the perceived risks that the Financial JUL OCT JAN APR temperature US$/ 2014 % Stability Board has launched an investigation to Bbl 2014 2015 to 2°C by the assess the potential fallout from the proposed end of the 2.4 measures to curb CO2 emissions. 36 century. 2.0 32 Reason 6: 1.6 The Taxman Wants His Cut 28

The discussion above raises an important 1.2 24 question: if increased supply pushes down oil prices, but environmental concerns constrain 20 .8 how much oil households and businesses are

allowed to use, what forces will equilibrate the JAN APR US$/ 1991 % market? Bbl 30 4.0 One possibility is that alternative energy

sources such as solar will squeeze out all but 26 3.6 the most efficient petroleum producers. This 3.2 22

2.8 18 2.4 3 International Energy Agency, “World Energy Outlook – 2012,” dated November 12, 2012, available at http://www. 14 worldenergyoutlook.org. 2.0 © BCA Research 2015 4 Mark C. Lewis et al., “Stranded Assets, Fossilised Revenues,” Kepler Cheuvreux, dated April 24, 2014, JUL OCT JAN APR JUL OCT available at http://www.keplercheuvreux.com. 1985 1985 1986 * WEST TEXAS INTERMEDIATE. ** DEFLATED BY CORE CPI.

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Discover CHART 11 Developed Economies Are Less Oil-Intensive what you OIL EFFICIENCY: OIL EFFICIENCY: can do BARRELS OF OIL CONSUMED* PER OIL* SPENDING RELATIVE 700 700 with BCA 140 MILLION U.S. DOLLARS OF REAL GDP** 140 TO NOMINAL GDP IN U.S. DOLLARS** Analytics. WORLD 600 WORLD 600 OECD OECD 120 120 NON-OECD COUNTRIES NON-OECD COUNTRIES 500 500

100 100 400 400

300 300 80 80

200 200

60 60 100 100

U.S. U.S. EUROPEAN UNION EUROPEAN UNION JAPAN 500 JAPAN 500

100 100 400 400

80 80 300 300

200 200 60 60

100 100 40 40

CHINA CHINA 2200 2200 180 180 1800 1800

140 140 1400 1400

1000 1000 100 100

600 600

60 60 200 200 © BCA Research 2015 © BCA Research 2015

70 80 90 2000 10 70 80 90 2000 10 * SOURCE: B.P. STATISTICIAL ENERGY REVIEW. * SOURCE: B.P. STATISTICIAL ENERGY REVIEW. ** SOURCE: WORLD BANK. ** SOURCE: WORLD BANK. NOTE: USES WEST TEXAS INTERMEDIATE PRICES FOR THE U.S., AND BRENT NOTE: ALL SERIES REBASED TO 1970 = 100. PRICES FOR OTHER COUNTRIES. ALL SERIES REBASED TO 1970 = 100.

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Half of the CHART 12 High-Cost Producers Are Vulnerable positive US$/ Mn Bbl/ impact on Bbl Day OIL PRODUCTION AND OPERATING COSTS BY COUNTRY global GDP OPERATING COSTS (LS) 10 from falling 40 OIL PRODUCTION (RS) oil prices has been 8 negated by 30 either higher 6 energy taxes or implicit 20 cuts to fuel 4 subsidies. 10 2

0 0 U.S. U.K. UAE IRAN IRAQ INDIA ITALY CHAD LIBYA OMAN CHINA EGYPT QATAR YEMEN BRAZIL GHANA GABON RUSSIA CONGO MEXICO KUWAIT BRUNEI BRUNEI NIGERIA ANGOLA CANADA ALGERIA VIETNAM NORWAY E.GUINEA ECUADOR THAILAND DENMARK MALAYSIA COLOMBIA INDONESIA AUSTRALIA ARGENTINA VENEZUELA AZERBAIJAN KAZAKHSTAN SAUDI ARABIA SAUDI SOUTH SUDAN SOUTH © BCA Research 2015 TURKMENISTAN

SOURCE: IMF WORLD ECONOMIC OUTLOOK (APRIL 2015).

would cause both oil prices and oil demand to decline, as Chart 13 illustrates with a simple supply and demand diagram.

Developing such alternative sources of energy will take time, however. In the interim, governments are likely to step in to suppress oil demand. This is not just a hypothetical consideration. Accord- ing to the IMF, nearly half of the positive impact on global GDP from falling oil prices has been negated by either higher energy taxes or implicit cuts to fuel subsidies in countries where oil is sold at below-market prices (Chart 14). This goes some distance in explaining why the boost to global aggregate demand from the plunge in crude prices has not been as great as many had anticipated.

Reason 7: Bad Weather And Other Bumps In The Road Finally, while U.S. households were benefiting from falling gasoline prices this winter, many were paying a lot more to heat their homes, owing to the exceptionally cold winter in the Northeast. We estimate that the colder-than-normal winter added $25 billion to household utility bills, nullifying about 20% of the gains from lower gasoline prices.

In addition, spending on health care surged by 6% at an annualized pace between Q3 of 2014 and Q1 of 2015. The good news is that most of that increase was due to a surge in the number

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Discover CHART 13 Oil Supply And Consumption Dynamics what you can do TWO WAYS IN WHICH OIL CONSUMPTION COULD FALL IN THE WAKE OF INCREASED SUPPLY: with BCA Analytics. Price D S of Oil SI

Households and firms demand less oil at Global oil supply any given price as new rises alternative energy sources become available DI

Oil equivalent amount of energy now supplied by alternative energy sources

Barrels of Oil QI Q Supplied / Demanded

Price D of Oil S

SI DI Government raises fuel taxes, which suppresses oil demand

Tax

Barrels of Oil QI Q Supplied / Demanded © BCA Research 2015

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Higher of people obtaining health insurance (health CHART 14 Government Policy Has Reduced Pass-Through care inflation averaged just 0.3% over this utility Of Lower Oil Prices To Consumers period). Nevertheless, the increase in outlays %% bills and IMF SIMULATION: increased on health care may have dampened spending 0 CHANGE IN REAL OIL PRICE 0 health care on other things. -20 -20 spending Taken together, higher utility bills and in- likely creased health care spending likely absorbed -40 -40 about 40% of the gains from lower gasoline CUMULATIVE IMPACT ON GDP RESULTING absorbed FROM A DECLINE IN THE EXPECTED OIL about 40% prices (Chart 15). PRICE SINCE AUGUST 2014* ASSUMING FULL PASS-THROUGH of the gains 1.2 LIMITED PASS-THROUGH** 1.2 In addition, growth in aggregate labor income from lower GLOBAL declined sharply in Q1, with the 3-month rate .8 .8 gasoline of change falling from 6.2% in January to 2.7% prices. in April, mainly on account of the sharp slow- .4 .4 down in the aggregate number of hours worked (Chart 16). This partly reflected the effects of 0 0 a stronger dollar: net exports shaved 1% off Q4 U.S.

GDP growth and 1.3% off Q1 growth. .8 .8

The stronger dollar should have been good .4 .4 news for the rest of the world. And for the 0 0 euro area, Japan, and most developed econo- EURO AREA mies, it was. However, for emerging markets, .4 .4 a stronger dollar also meant an increase in the .3 .3 local-currency value of dollar-denominated .2 .2 debt liabilities. This likely had a contractionary .1 .1 effect on EM growth, adding to the woes that 0 0 many commodity-exporting economies were CHINA already experiencing. 1.6 1.6 1.2 1.2 .8 .8 What Does This Mean For Investors? .4 .4 0 0 The preceding discussion gives some hope that INDIA U.S. growth should improve over the next few quarters. The weather has returned to normal, .8 .8

health care spending has slowed over the past .4 .4 few months, the dollar appears to stabilizing, 0 © BCA Research 2015 0 and energy capex may begin to bottom now 14 15 16 17 18 19 20 that rig count has fallen by 50% (Chart 17). * MODEL BASED ON SUPPLY SHOCKS AND ASSUMES A FULL OR LIMITED PASS-THROUGH TO FINAL DOMESTIC PRICES. Furthermore, if our Commodity team’s projec- ** LIMITED PASS-THROUGH ADJUSTS FOR GOVERNMENT POLICIES (SUCH AS GASOLINE TAXES) THAT IMPEDE SOME OF THE POSITIVE BENEFITS ACCRUED tion that WTI oil prices will fall to the mid-40s TO HOUSEHOLDS AND FIRMS FROM LOWER OIL PRICES. SOURCE: IMF WORLD ECONOMIC OUTLOOK (APRIL 2015). in the second half of this year and recover to

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Discover CHART 15 Utilities And Health Care Spending Bit Into Oil Windfall what you US$ US$ can do Tn Tn CONSUMER SPENDING ON GASOLINE, HEATING, AND HEALTH CARE with BCA PRE-JUNE 2014 TREND 2.75 Above-trend 2.75 Analytics. spending on home heating Above-trend 2.70 2.70 spending on health care

2.65 2.65

2.60 2.60

Below-trend spending on 2.55 gasoline 2.55

JUL OCT JAN APR JUL OCT JAN 2013 2013 20142014 2015 NOTE: BCA CALCULATIONS.

only the mid-50s by the end of the decade CHART 16 proves to be correct, skeptical households may Weak Growth Has Weighed On Labor Income %% begin to open their wallets a bit more than they U.S. AGGREGATE PRIVATE LABOR INCOME have so far. 7 7

Yet, as noted above, in the wake of the financial 6 6 crisis, many households appear more eager to 5 5 save the windfall from lower oil prices than to spend it. At the same time, governments could 4 4 find it hard to resist the temptation to raise fuel 3 3 taxes. While the additional tax revenue may

eventually flow back to households in the form %% 12-MONTH RATE OF CHANGE of increased transfers, some of it is likely to be 3-MONTH RATE OF CHANGE, ANNUALIZED 6 6 used to shore up government balance sheets. AGGREGATE PRIVATE HOURS WORKED Ironically, this suggests that lower oil prices, rather than lifting equilibrium real rates by 4 4 stoking aggregate demand, could actually put

downward pressure on bond yields to the extent 2 2 that governments use the proceeds from higher fuel taxes to pay back debt. This supports our overall bullish view of bonds, especially in the 0 © BCA Research 2015 0 case of relatively “high yielding” Treasurys. 12 13 14 15

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A prolonged CHART 17 CHART 18 Rig Counts Have Adjusted Rapidly RUB And BRL Are Still Expensive period of US$/ US$/ Bbl Bbl low oil prices U.S. REAL* OIL** PRICES HORIZONTAL OIL RIG COUNT 140 140 is clearly 1400 1400 bearish for 120 120 oil exporting 100 100 economies. 1200 1200 80 80

60 60

40 40 1000 1000

180 REAL EFFECTIVE EXCHANGE RATE***: 180 BRAZILIAN REAL

800 800

140 140

With respect to currencies, a prolonged period 60 60 of low oil prices is clearly bearish for oil export-

ing economies. Chart 18 shows that the real RUSSIAN RUBLE trade-weighted value of the Brazilian real and 140 140 Russian ruble is still much higher than in 2005, 120 120 which corresponds to the last time inflation- 33% too adjusted oil prices were at today’s levels. expensive 100 100 Lower oil prices are a negative for the euro, given that Europe has historically received a 80 80 disproportionate share of petrodollar flows. That 60 60 said, it is doubtful that the Fed will be able to © BCA Research 2015 raise rates anywhere close to 3.5%-3.75%, as 2000 02 04 06 08 10 12 14 16 * DEFLATED BY HEADLINE CPI, IN 2015 PRICES. implied by the “dots” in the Summary of Eco- ** AVERAGE OF BRENT AND WEST TEXAS INTERMEDIATE. *** REBASED TO MAY 2005 = 100, BASED IMF DATA. LATEST nomic Projections. This, in turn, should keep DATAPOINT IS A BCA ESTIMATE. a lid on the greenback. On balance, we expect the dollar to strengthen modestly against the euro, ultimately settling in a range of parity to $1.1 for the remainder of the year. We are somewhat more constructive on the yen, reflecting its cheap valuation and the fact that lower oil prices should reduce Japan’s oil import bill.

Peter Berezin, Managing Editor [email protected]

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Strategy & Market Trends*

EQUITY PRICES / WORLD BOND SHORT CURRENCY BENCHMARKS** YIELDS RATES VS. US$

U.S. DOWN DOWN FLAT

CANADA FLAT DOWN DOWN DOWN

JAPAN UP FLAT FLAT FLAT

AUSTRALIA FLAT DOWN DOWN FLAT

U.K. FLAT DOWN FLAT DOWN

EURO AREA UP FLAT FLAT DOWN

EMERGING ASIA UP DOWN DOWN DOWN

LATIN AMERICA DOWN FLAT FLAT DOWN

* EXPECTATIONS FOR THE COMING SIX WEEKS TO THREE MONTHS BASED ON A COMBINATION OF OUR ASSET ALLOCATION MODEL, ANALYSIS AND INTUITION. **EQUITY PRICES RELATIVE TO WORLD BENCHMARK EXPRESSED IN LOCAL CURRENCIES.

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Tactical Trades The purpose of this section is to provide investment ideas independent of our asset allocation model or direct market forecasts. Once recommended, we will monitor the investment recommendation until we close it out. INITIATION RETURN-TO- TRADE INCEPTION LEVEL STOP COMMENTS DATE DATE

LONG GLOBAL CYCLICALS / 100 MAY 1/15 -2.1% 95 SHORT GLOBAL DEFENSIVES*

LONG EURO AREA BANK STOCKS 50.12 JAN 16/15 26.9% 51.87 HEDGE CURRENCY EXPOSURE.

LONG S&P DIVIDEND 0.3370 OCT 24/14 -4.2% 0.3200 ARISTOCRATS / SHORT NASDAQ

LONG CHINA H-SHARE INDEX** 11922.56 MAY 23/14 62.0% 13038.5 PREVIOUSLY LONG A-SHARE INDEX.

LONG 10-YEAR U.S. TREASURYS / 100 AUG 15/14 16.2% 100 UNHEDGED. SHORT 10 YEAR GERMAN BUNDS

LONG CRB METALS INDEX / 100 MAY 8/15 -4.6% 95 SHORT WTI CRUDE OIL

LONG U.S. DOLLAR (DXY INDEX) 86.915 OCT 31/14 10.5% 90.00

LONG 12-MONTH NDF USD/CNY 6.4025 MAR 6/15 -2.5% 6.2000

NOTE: STOPS ARE BASED ON DAILY CLOSING LEVELS. PLEASE NOTE THAT ALL CURRENCY TRADE CALCULATIONS INCLUDE COST OF CARRY. * CYCLICALS INCLUDE MATERIALS, ENERGY, INDUSTRIALS, AND CONSUMER DISCRETIONARY; DEFENSIVES INCLUDE TELECOM, CONSUMER STAPLES, AND HEALTH CARE. ** LONG CHINESE BANKS FROM MAY 23, 2014 UNTIL OCTOBER 17, 2014; LONG CHINESE A SHARES FROM OCTOBER 17, 2014 TO FEBRUARY 13, 2015.

Strategic Recommendations This table summarizes our longer-term strategic recommendations. Some of these positions may not necessarily be consistent with our “Tactical Trades”. RETURN AS OF CURRENT POSITION INCEPTION INITIATION COMMENTS LEVEL DATE LAST WEEK RETURN

EQUITY RECOMMENDATIONS SHORT U.S. / LONG BASKET OF EURO AREA, JAPANESE, 100 FEB 2015 9.0% 10.7% AND CHINESE EQUITIES1 FIXED INCOME RECOMMENDATIONS LONG GERMAN 10-YEAR CPI SWAP 151 BPS FEB 2015 29 BPS 26 BPS LONG U.S. 30-YEAR / SHORT U.S. 10-YEAR GOV’T BONDS 96.0 BPS FEB 2014 9.5% 9.7% OVERWEIGHT AUSTRALIA (ADD CURRENCY HEDGE)2 100 JAN 2009 50.2% 50.1% OVERWEIGHT NEW ZEALAND (ADD CURRENCY HEDGE)2 100 JAN 2009 53.3% 52.5% LONG ITALIAN 10-YEAR GOV’T BONDS 5.878% AUG 2012 36.8% 32.9%

CURRENCY RECOMMENDATIONS LONG AUSTRALIAN DOLLAR / 1.0815 APR 2014 -1.4% -2.1% SHORT NEW ZEALAND DOLLAR

1 EQUALLY-WEIGHTED BASKET. HEDGE CURRENCY EXPOSURE. 2 CURRENCY HEDGE ADDED AS OF SEPTEMBER 26, 2014. NOTE: RETURNS RELATIVE TO BENCHMARK. MSCI WORLD FOR EQUITY RECOMMENDATIONS UNLESS OTHERWISE SPECIFIED. CUSTOM BENCHMARK FOR FIXED-INCOME RECOMMENDATIONS BASED ON GDP-WEIGHTED G10 GOVERNMENT BOND PERFORMANCE.

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