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Stock rally is on pause

by SuperiorInvest

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Good day. The good news was bad news after yesterday's excellent retail sales numbers. Yields jumped across the curve, led by long-term yields, and the Nasdaq fell about 2 percent. Curiously, however, the two-year yield only increased a little. What is the long ending trying to tell us? We tried to find an answer below, but they intervened: robert.armstrong@ft.com and ethan.wu@ft.com.

A flat market

Around March 20, the stock market stopped rising and started moving sideways. This chart dates back to when the rally began, last October:

Something Changed Line Chart Around March 20 Showing When the Music Stopped

What happened on March 20? On the one hand, a Fed meeting and press conference, in which Jay Powell assured the markets that, despite the overly warm January and February CPI inflation reports, the Open Market Committee's attitude toward Rate cuts remained unchanged:

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

I don't want to suggest that Powell managed to curse the market. Rather, his comments may have represented maximum 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, a number of things have happened that suggest we may not be living in the best of all possible worlds. On April 1, an inauspicious date, Israel bombed the Iranian consulate in Damascus, which has made oil, which was already rising, rise a little more (see next point). The next day, Tesla, whose Mag Seven membership was already weak, reported a sharp drop in unit sales. April 10: Another uncomfortably spicy CPI report. On the 12th, JPMorgan Chase, the world's largest bank, disappointed the market with its outlook on credit margins and the stock fell. Then yesterday, a spectacular retail sales report confirmed the idea that the economy was in full swing and the market didn't like it at all.

Note the mix of different types of news. It's not just that higher inflation and a strong economy suggest that rate cut expectations should be reversed, but that the technology-is-everything narrative is being dented (Tesla), higher rates hurt (JPMorgan) and global anguish finally making its presence felt (Israel-Iran).

Still, the stubborn link between inflation, high growth and higher rates for longer is clearly the main explanation for market stagnation. There is more to this than simple rate cut expectations, which have been steadily retreating since January. But after March 20, real and nominal long rates, which had been trending sideways, began to perk up.

Line chart showing the long end.

To us, this smacks a bit of regime change: from an ideal world of strong growth, normalized inflation and falling rates to a world of strong growth, persistent inflation and rates that remain quite high (and all of this, potentially, for quite a while). time.

Why has oil gone up?

Brent crude oil prices are at $90, up 17 percent this year. Because?

Line chart of Brent crude oil price per barrel, in dollars showing crude oil, crude oil world

Most obviously, people are worried about the conflict between Iran and Israel. 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 rose 30 percent to 3.3 million barrels per day, about 3 percent of the World production. Disruptions to all that would hurt. The fact that this weekend's missile and drone attacks on Israel have produced a negligible reaction in oil prices suggests that some geopolitical risk has already been priced in. (Analyst estimates of the geopolitical risk premium range between $5 and $10.)

But market fundamentals have been the most important force behind oil's rise, surprising many energy observers. In January, the International Energy Agency projected a “substantial surplus” of oil supply. In March, its forecast changed to “slight deficit”, a conclusion maintained in the IEA's latest April forecast. Since February, as fundamentals have become clearer, investors have increased their long bets on West Texas Intermediate contracts:

Line chart of fund managers' net long positions on WTI crude oil, millions of barrels showing many oil bulls out there

How do we get here? First, demand has been stronger than expected. The strong macroeconomic outlook that Unhedged has been harping on has not gone unnoticed by oil traders. A revival of the global manufacturing sector (see chart below), strong employment in the United States and positive outbreaks in China's activity data are lifting energy demand. Since Covid-0 ended, Chinese demand has been consistently strong and, in percentage terms, Indian demand will be the fastest growing this year.

Line chart of manufacturing purchasing managers' indexes (below 50 indicates contraction) showing global rebound

Secondly, OPEC+ supply cuts have begun to take effect. Combined with strong demand that made the supply cuts more impactful, in March the cartel agreed to extend the supply cuts that were due until June. Some argue that OPEC+ will ease cuts later this year, citing ample spare capacity and oil prices above many members' “fiscal balances,” the price that balances petrostate budgets. But Robert Ryan, veteran energy strategist at BCA Research, is on the other side: “History says it has been a bad bet going against Saudi Arabia. [To realise their Vision 2030 economic diversification plan] “They want Brent crude prices of more than $90.”

Third, other supply disruptions have emerged. Houthi maritime attacks in the Red Sea have led to an increase in oil trapped on ships. Pemex, Mexico's state oil company, is curbing exports as part of an effort for self-sufficiency. And cold weather in the United States earlier this year wiped out 800,000 barrels per day of production, leading to a drawdown in reserves that have yet to be replenished.

In any commodity market, one must ask: will high prices cure high prices? In particular, could increased oil production in the United States, the world's undecided producer, cover the “slight shortfall” that the IEA predicts? There are reasons to think so. As Goldman Sachs analysts point out in a recent note, US oil production in the first quarter has been held back by several transitory factors, including unusually cold weather, normal seasonality and an oversupply of natural gas (which forces frackers to hold back).

As these fade, U.S. producers could begin to respond to rising oil prices. Bradley Waddington of Longview Economics argues that recent US survey data bodes well for the rise of producers:

WTI oil prices are currently $21 above breakeven prices for shale producers. [ie, the prevailing oil price needed to profitably dig new wells]. That's up from just $4 at the December lows. Widening that margin should encourage shale producers to turn on the supply taps again. . .

Other survey indicators confirm the strengthening of US production. Capital spending expectations among shale producers for the next 12 months, for example, have risen to high levels. . . Confirming that, the number of platforms in the US has begun to increase

However, even if Waddington were right, it is difficult to imagine that increased American supply would drive down prices substantially. U.S. energy producers remain constrained by investors' insistence that they show capital discipline. This has been reflected in the number of platforms, which collapsed in 2023 and are only now recovering. American producers have put aside their “genius for destroying capital,” says BCA's Ryan, and are now desperate to maintain access to equity and debt markets by generating free cash flow.

The fact of the matter is that any future geopolitical disruption to supply could disrupt a delicately balanced oil market at best and risk pushing the world into an energy deficit. (Ethan Wu)

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