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The equity rally is on pause

Good morning. Good news was bad news after yesterday’s hot retail sales numbers. Yields leapt across the curve, led by long-term yields, and the Nasdaq fell about 2 per cent. Curiously, though, the two-year yield was only up a smidgen. What is the long end trying to tell us? We try our hand at an answer below, but do chime in: robert.armstrong@ft.com and ethan.wu@ft.com. 

A flat market

On or around March 20, the stock market stopped rising and started moving sideways. This chart goes back to when the rally began, last October:

Line chart of Something changed around March 20 showing When the music stopped

What happened on March 20? For one thing, a Fed meeting and press conference, at which Jay Powell reassured the markets that, despite too-warm CPI inflation reports for January and February, the Open Market Committee’s attitude towards rate cuts was unchanged: 

As labour market tightness has eased and progress on inflation has continued . . . we believe that our policy rate is likely at its peak for this tightening cycle, and that if the economy evolves broadly as expected, it will probably be appropriate to begin dialling back policy restraint at some point this year . . .

I don’t want to suggest that Powell managed to jinx the market. Rather, his comments may have represented peak optimism. The market, one might have thought on the 20th, would get full employment, strong economic growth, steady disinflation, rate cuts and possibly a pony. 

Since then, assorted things have happened to suggest that we might not be living in that best of all possible worlds. On April 1, an inauspicious date, Israel bombed the Iranian consulate in Damascus, which has nudged oil, already rising, a bit higher (see next item). The next day, Tesla, its membership in the Mag Seven already tenuous, reported sharply declining unit sales. April 10: another uncomfortably spicy CPI report. On the 12th, JPMorgan Chase, the most important bank in the world, disappointed the market with its outlook for lending margins, and the shares fell. Then, yesterday, a blowout retail sales report confirmed the idea that the economy was running hot, and the market did not like it at all. 

Note the mix of different sorts of news. It’s not just that higher inflation and a strong economy suggest that rate cut expectations have to be rolled back, but the tech-is-everything narrative getting dented (Tesla), higher rates biting (JPMorgan) and global distress finally making its presence felt (Israel-Iran).

Still, the stubborn inflation/high growth/higher-for-longer rates nexus is clearly the main explanation for the market going flat. There is more to this than just rate cut expectations, which have been in steady retreat since January. But after March 20, real and nominal long rates, which had been trending sideways, started perking up. 

Line chart of  showing The long end breaks out

To us, this smells a little of regime change: from an ideal world of strong growth, normalising inflation, and falling rates to a world of strong growth, stubborn inflation, and rates that stay quite high — and all of this, potentially, for quite some time. 

Why oil has surged

Brent crude prices are at $90, up 17 per cent this year. Why? 

Line chart of Brent crude price per barrel, $ showing Crude, crude world

Most obviously, people are worried about the Iran-Israel conflict. A fifth of the world’s oil passes through the Strait of Hormuz, and over the past year, Iran’s contribution to global crude supply has risen 30 per cent to 3.3mn barrels per day, about 3 per cent of world production. Disruptions to any of that would hurt. That this weekend’s missile-and-drone attacks on Israel produced a negligible reaction in oil prices suggests some geopolitical risk was already priced in. (Analyst estimates of the geopolitical risk premium run around $5-$10.)

But market fundamentals have been the more important force behind oil’s run-up, which has surprised many energy watchers. In January, the International Energy Agency was projecting a “substantial surplus” of oil supply. In March, its forecast flipped to “slight deficit”, a conclusion maintained in the IEA’s latest April forecast. Since February, as the fundamentals became clearer, investors have ramped up their long bets on West Texas Intermediate contracts:

Line chart of Fund managers'  net long positions on WTI crude, mn barrels showing Lot of oil bulls out there

How did we get here? First, demand has been firmer than expected. The strong macro picture Unhedged has been harping on about has not been lost on oil traders. A global manufacturing revival (see chart below), strong US employment and green shoots in Chinese activity data are lifting energy demand. Since zero-Covid ended, Chinese demand has been consistently strong, and in percentage terms, Indian demand is set to be the fastest-growing this year.

Line chart of Manufacturing purchasing managers' indices (below 50 indicates contraction) showing Global upswing

Second, Opec+ supply curtailments have started to bite. Combined with strong demand making supply cuts more impactful, in March the cartel agreed to extend expiring supply cuts until June. Some argue that Opec+ will loosen cuts later this year, citing ample spare capacity and oil prices above many members’ “fiscal break-evens”, the price that balances petrostates’ budgets. But Robert Ryan, BCA Research’s veteran energy strategist, takes the other side: “History says it’s been a bad bet to go against Saudi. [To realise their Vision 2030 economic diversification plan] they want $90-plus Brent crude prices.” 

Third, other supply disruptions have cropped up. Houthi shipping attacks in the Red Sea have led to a jump in oil stuck on ships. Pemex, Mexico’s state-owned oil company, is curbing exports as part of a self-sufficiency push. And cold weather in the US earlier this year took out 800,000 barrels per day of production, leading to a drawdown in stockpiles that has yet to be replenished.

In any commodity market, one has to ask: will high prices cure high prices? In particular, could higher oil output in the US, the world’s swing producer, fill the “slight deficit” the IEA foresees? There are reasons to think it can. As Goldman Sachs analysts point out in a recent note, first-quarter US oil production has been held back by several transitory factors, including unseasonably cold weather, normal seasonality and oversupply in natural gas (which forces frackers to hold back).

As these fade, US producers could start responding to higher oil prices. Bradley Waddington of Longview Economics argues that recent US survey data bodes well for producers ramping up: 

WTI oil prices are currently $21 above shale producers’ break-even prices [ie, the prevailing oil price needed to profitably dig new wells]. That’s up from just $4 at the lows in December. The widening of that margin should encourage shale producers to turn the supply taps back on . . . 

That case for stronger US production is confirmed by other indicators within the survey. Capex expectations among shale producers for the next 12 months, for example, have increased to high levels . . . Confirming that, US rig counts have started to turn higher

Even if Waddington is right, however, it is hard to see added US supply substantially driving prices down. US energy producers remain constrained by investors’ insistence that they show capital discipline. That has been reflected in rig counts, which collapsed in 2023 and are only now recovering. US producers have set aside their “genius for destroying capital”, says BCA’s Ryan, and are now desperate to maintain equity and debt market access by generating free cash flow. 

The punchline is that any future geopolitical supply disruptions could hit an oil market that is, at best, delicately balanced, at risk of tipping the world into an energy shortfall. (Ethan Wu)

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