Weekly Energy Update (June 22, 2023)

Posted on June 22, 2023 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Oil prices may be establishing a new trading range between $67 and $75 per barrel.

(Source: Barchart.com)

Commercial crude oil inventories fell 3.8 mb when compared to the forecast build of 0.5 mb. The SPR fell 1.7 mb, putting the total draw at 5.6 mb.

In the details, U.S. crude oil production fell 0.2 mbpd to 12.2 mbpd. Exports rose 1.3 mbpd, while imports declined 0.2 mbpd. Refining activity declined 0.6% to 93.1% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. After accumulating oil inventory at a rapid pace into mid-February, injections first slowed and then declined. This week’s draw is consistent with seasonal norms. The seasonal pattern would suggest that stocks should fall in the coming weeks, but this pattern has become less reliable due to export flows.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $58.21. Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories. With another round of SPR sales set to happen, the combined storage data will again be important.

Total stockpiles peaked in 2017 and are now at levels last seen in 2002. Using total stocks since 2015, fair value is $93.15.

Market News:

The Netherlands is closing Europe’s biggest natural gas fields due to local concerns about earthquakes. Often oil and gas extraction can lead to earthquakes; Oklahoma has experienced similar issues. This decision, though, will put the EU at risk of supply shortages.
The war in Ukraine has led to a massive restructuring of the global energy market. LNG has become an important fuel, and there has been a clear expansion of its use. This expansion has led to a rapid increase in the infrastructure for the fuel, including gasification plants in the Middle East, Australia, Canada, and the U.S.
- China has embarked on long-term contracts with suppliers, which establish the funding for investment. The EU, likely because of expectations of renewable growth, is less open to long-term contracts. If natural gas usage continues, Europe could find itself isolated.
- Russia’s oil refineries hit new highs in utilization, which may mean that Russia intends to meet its OPEC+ obligations by replacing oil exports with product exports. Russian oil exports have been affected by the war.
- Russia’s oil flows to India have been at deep discounts, helping to improve India’s economy.
- Russian natural gas is still flowing through Ukraine, but the current agreement ends next year, and Kyiv expects Russian gas flows to stop.
There are some unusual actions being taken by the Kingdom of Saudi Arabia (KSA) regarding oil flows. For example, consistent with its decision to reduce oil flows, Saudi oil exports fell to a five-month low in April. However, there are numerous reports that the KSA is storing 20 mb of oil on 10 tankers in the Red Sea. We also note a spike in supertanker rates, which may be tied to the KSA’s decision to float oil storage.
- The Permian Basin is now producing more oil than the KSA’s giant Ghawar field.
- So far, the KSA’s bid to boost prices has failed to work.
The summer solstice came this week, marking the onset of astrological summer (meteorological summer began on June 1). We are seeing a strong heatwave in the South, especially in Texas. Hot weather boosts electricity demand and usually is bullish for natural gas prices. We note Texas degree days are running well above normal.

(Source: Reuters)

- Texas isn’t alone in its drought; Iran is facing a crisis as well.

Mexico has joined several firms in a deep-water oil and gas project.
Guyana is delaying offshore oil-block auctions in a bid to increase the number of participants in its oil exploration.
Ship channel dredging will allow larger oil tankers to directly load oil and products from the Texas coast.
The DOE suffered a data breach tied to Russian hackers.
- DOE Secretary Granholm failed to disclose stock holdings; it is unclear if this fact will lead to her ouster.

Geopolitical News:

The U.S. is still buying uranium from Russia for American power plants. Although nuclear power is an attractive alternative energy, the lack of a non-Russian supplier is a risk.
One of Russia’s long-term geopolitical goals is a warm water port. Although the warming of the Arctic may give Moscow the sea access it wants, it has eyed the Middle East as a possible path to the ocean. As Iranian and Russian relations improve, Russia is looking to build access to the Indian Ocean through Iran. A risk to this path is that the Arab states in the Persian Gulf have tended to side with the U.S. However, as relations fray between Washington and these Arab states, the risks in using Iran for sea access decline. Thus, the recent thaw between Riyadh and Tehran is a benefit to Moscow.
We are seeing a concerted effort by China to secure energy sources. China appears to be deploying an “all of the above” strategy, including both alternatives and fossil fuels. What is important here is that China is most interested in energy security, with less regard for the source.
Central Asia isn’t just the focus of China and Russia. Germany is also looking to secure energy from the region and held talks with Kazakhstan
As we noted last week, we were mostly wrong about an Iran nuclear deal. What we got right was that the JCPOA was dead. What we didn’t expect was that the U.S. would opt for a limited deal in what looks like a bid to reduce regional tensions. We doubt this will increase global oil supplies much since Iranian sanctions are far from tight, but easing tensions will likely make more oil available to the West. We suspect the White House is fully focusing on November 2024, and although there will be a political cost to a thaw, the chances of lower oil prices are probably seen as a greater benefit.
- It isn’t clear what will actually be agreed to in the deal. The U.S. appears willing to accept Iranian uranium enrichment to around 60%, which is less than weapons-grade but still shows that the country can reach the 98% required for bombs. Particles enriched to nearly 84% have already been reported.
- Iran will receive some funds that are currently frozen, and the U.S. will get prisoners freed.
The KSA has invited Iran’s president to Riyadh for an official visit.
China has agreed to build a nuclear power plant in Pakistan.
Here is a cool map of China’s energy infrastructure.

Alternative Energy/Policy News:

One of the emerging themes for the next few years will be the choice Western nations face on EVs. If the goal is extensive adoption, the most effective way of achieving this is to allow Chinese imports. China’s EV industry has improved rapidly and is now producing world-class cars at reasonable prices. On the other hand, if the goal for Western nations is re-industrialization, Chinese cars should be restricted. So far, we have generally expected Europe to be much more open to Chinese EVs compared to the U.S. However, there is evidence that the EU is rethinking that position.
- Tesla (TSLA, $268.75) is rapidly becoming the connection standard for the EV industry as more EV makers adopt its standard. Doing so gives car owners access to Tesla’s charging stations.
In fact, meeting climate goals is often in direct conflict with meeting geopolitical goals. There are serious doubts as to whether the West can move toward carbon neutrality without China.
Solid state EV batteries have the potential to revolutionize the industry. Toyota (TM, $157.40) has a test vehicle it claims has a range of 932 miles with a 10-minute charge. If high range/short charging becomes the norm, ICE vehicles will be much less attractive.
The U.S. is leading a critical minerals partnership in a bid to create a strong supply chain for metals needed for the energy transition. Presently, China holds a commanding position in these metals, but the U.S. and its allies want to build a supply network that prevents China’s dominance.
- It should be remembered that part of the reason for China’s dominance is that it was willing to accept the environmental costs of mining and processing these metals.
- The U.S. is facing calls from nations with key minerals but without free trade agreements with the U.S. to join this partnership. So far, Washington has restricted the subsidies, but if the U.S. doesn’t expand the list, China might become an alternative funder.
- Minnesota may become an important source of nickel, but the permitting process could be daunting.
Chinese regulators approved a thorium reactor. Thorium reactors have some major advantages over uranium reactors. They didn’t get used in the early days of nuclear power because nations wanted the dual option of being able to make nuclear weapons, and thorium can’t be weaponized. In addition, this reactor will use molten salt, which is another significant benefit.
Hydrogen is a fuel that offers promise in providing clean power but tends to fail at gaining traction due to costs. The U.K. is looking to use the fuel for home heating but is struggling with the details. In the EU, there is a program to expand the pipeline network to move hydrogen.
The U.K. has opened its first deep geothermal project in 37 years.
Although there is great hope for fusion power, the reality is that we are a long way from commercial fusion power.
The Biden administration announced an increase in biofuel use, but surprisingly, the ethanol mandate was less than expected. Even with other biofuels, the mandates were less than expected. Biofuels replace fossil fuels to some extent, but also still require fossil fuels in production. In general, biofuels are more about reducing U.S. dependence on foreign oil and are an aid to farmers. Corn ethanol, for example, reduces greenhouse gas emissions by 19% compared to gasoline. The best benefit comes from biomass and cellulosic ethanol. But because neither comes from a cash crop, support for these fuels is lacking.

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Daily Comment (June 22, 2023)

Posted on June 22, 2023June 22, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Signals of higher rates from central banks are leading to a general risk off day. Interest rates are higher, while equities are generally lower as are commodities.

In today’s Comment, we lead off with the central bank news. Next up is PM Modi’s visit to Washington. President Biden’s most recent gaffe has upset China; we also note trade news related to China. An update on the war in Ukraine comes next, and we close with a roundup of international news.

Central Banks: There is a plethora of central bank news this morning. Tightening monetary policy puts the global economy at risk.

In response to higher U.K. inflation, the BOE raised rates 50 bps this morning, taking the bank’s policy rate to 5.00%, a 15-year high. A combination of factors has lifted inflation, including labor action, trade disruptions still lingering from Brexit, and the lack of immigration. U.K. retailers are reporting a rise in shoplifting. Shopkeepers believe that higher prices, which are causing a decline in living standards, are tempting shoppers to steal.
Chair Powell travels to Capitol Hill again today, this time visiting the Senate. Yesterday, the head of the Federal Reserve Open Market Committee clearly signaled that the most recent pause in rates most likely didn’t indicate the end of the current tightening cycle. Even the Fed’s most “lonesome dove,” Chicago FRB President Goolsbee, is uncertain about the direction of the next move; he isn’t calling for rate cuts. In response to the hawkish tone, the yield curve inverted sharply as long-duration Treasuries tend to rally on hopes the Fed will corral inflation.
Meanwhile, the Senate appears close to approving the White House selections for Fed governors. Governor Jefferson is up for vice-chair, Governor Cook is up for a full 14-year term, and Adriana Kugler will fill the last open seat on the committee.
Turkey, facing a serious inflation problem, nearly doubled its policy rate to 15% from 8.5%. The country’s president has argued that raising interest rates causes inflation but in the wake of his reelection, he seems to be adopting a more orthodox policy stance. Despite the move, the markets wanted more; the TRY fell on the news.
Norway and Switzerland also raised policy rates today.

Modi to Washington: Over the years, the U.S. has had mixed relations with India. During the Cold War, India was a key member of the non-aligned movement, which attempted to avoid taking sides in the global division. That policy continued after the Cold War ended. India has been a major buyer of Soviet/Russian defense material and has benefited greatly by purchasing Russia oil at deep discounts. Washington has been troubled by India’s treatment of minority groups. Still, as U.S. relations with China deteriorate (see below), Washington has been attempting to woo India into a bloc designed to isolate China. As part of that effort, PM Modi is in Washington for a state visit with full honors. We note that the U.S. is offering to sell India defense goods in a bid to improve relations and perhaps wean New Delhi off Russian military equipment.

Oops, I Did It Again: After SoS Blinken traveled to China in an attempt to stabilize relations, President Biden triggered a row after calling President Xi a “dictator.” Chinese officials were not amused by the comment, and the gaffe sent U.S. officials scrambling to respond. It’s unclear if the comment will cause lasting damage, but the timing does thwart recent efforts to improve relations.

China and trade: German Chancellor Scholz and Chinese Premier Li held meetings in Berlin this week where the chancellor pressed China for a “level playing field.” Germany is heavily dependent on the Chinese economy and Scholz is considered a dove on China. Meanwhile, the EU appears to be tightening trade and investment policy toward China in actions resembling American policy. China’s “dual circulation” economic policy is designed to reduce China’s global dependence while simultaneously increasing the world’s dependence on China. The WSJ points out that the U.S. has avoided trade deals as a way to counter China, the most obvious being the Trans-Pacific Partnership. The U.S. position is that trade deals have tended to boost China’s global integration, something that Washington is trying to weaken.

Ukraine Update: The Ukraine counteroffensive continues to grind on.

Although the conflict continues, policymakers are starting to discuss the rebuilding of Ukraine after the war ends. EU officials are considering seizing frozen Russian foreign reserves, which could bring up to $200 billion. The action is probably illegal under international law, but making Russia pay for damages caused by the war is tempting.
Ukrainian missiles have apparently damaged a key bridge supplying Russian troops in the Kherson region.
Although the Russian president’s domestic political situation appears to be secure, he has faced consistent criticism from the political right wing in Russia. A Russian commentator suggested that China should send a couple of million troops from the PLA to assist Russia in the war in Ukraine. Although that isn’t likely to happen, the comment inadvertently highlights one of the fallouts from the war, which is Russia’s increasing dependence on China.
National Security Advisor Sullivan will travel to Denmark this weekend to meet with representatives from nations in the Global South that have remained neutral in the conflict in a bid to sway them to support Ukraine. It is unclear if Sullivan will change minds but getting support from these holdouts would be a PR win.

International Roundup: Here are other news items of note.

Brazil’s former president is in court and facing a potential eight-year ban from political office on charges that he abused his presidential powers in recent elections.
French police have raided the headquarters for the 2024 Olympics in a corruption probe.
Moldova, which has been trying to fend off Russian pressure, has banned the pro-Russian Shor party.

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Daily Comment (June 21, 2023)

Posted on June 21, 2023June 21, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts on investor concerns regarding Federal Reserve Chair Jerome Powell’s testimony to Congress later today. Next, we discuss how China may jump start its economy without relying solely on policy stimulus. Lastly, we explain why India’s growing prominence makes it an attractive investment target.

Powell Speaks: Investors’ fears of a more hawkish Federal Reserve have weighed on equity performance.

Fed Chair Jerome Powell is slated to testify before Congress this week about the state of the economy and monetary policy. He is expected to provide clarity on the future path of interest rate hikes after markets were previously left confused following his comments at the Federal Open Market Committee’s meeting on June 13-14. Powell will also update lawmakers on the state of the banking system following the turmoil that took place in March.
The S&P 500 closed down 0.4% on Tuesday as strong economic data reinforced fears that Powell will deliver a hawkish message during his testimony to Congress. Despite concerns that the U.S. economy could fall into recession sometime this year, new government data showed that the economy remains resilient. Housing starts, a leading economic indicator, rose to their highest level in 14 months. The Atlanta Fed’s GDPNow model also estimates that real GDP growth rose 1.9% in the second quarter, slightly higher than the previous quarter’s reading of 1.3%.
- The current CME FedWatch Tool shows that there is now only a 5% chance that the FOMC will hold rates below 5% before the end of the year, much lower than the 90% chance it predicted a month ago.

(Source: CME)

It is unclear whether the Federal Reserve will ease off its inflation-fighting efforts as the economy heads into recession. Recent speeches from Fed officials suggest that they are more likely to hold interest rates stable in order to contain inflation, even if it means causing economic pain. This outcome would help accelerate the decline of inflation, but it would come at a cost. Therefore, any comments from Powell about the economy being resilient should be interpreted as evidence that the Fed is still committed to its hawkish monetary policy.

Emerging Markets: While the lack of stimulus in China may be a cause for concern, investors should not completely turn their backs on other emerging market countries.

China’s reluctance to provide sufficient stimulus to its economy has weighed on investor sentiment. Despite hints that the government would offer support after the country ended its Zero-COVID restrictions, it has yet to do so. Additionally, Chinese banks have not lowered lending rates as sharply as investors had expected following a series of rate cuts by the People’s Bank of China. Concerns about the country’s economy have pushed the offshore yuan (CNY) to 7.2 against the dollar, its lowest level since November. The currency has declined 4% since the start of the year and is the second worst-performing currency behind the yen (JPY).
The drop in the CNY has been so fast that it has been speculated that the country may be looking to grow through exports. On Wednesday, the PBOC set the CNY’s reference rate to 7.1795 per dollar, weaker than the previous fix of 7.1596. This decrease in the country’s currency comes after government data showed Chinese exports slowed more than expected in May. As a result, the country may receive a boost through trade, especially if meetings with U.S. Secretary of State Antony Blinken go well.

While China is a significant emerging market, investors should not overlook the opportunities offered by other individual countries. For example, Argentine stocks have risen 6.0% over the last seven days, highlighting the upside of looking abroad. The recent surge in stock prices in developing countries is likely due to a number of factors, including investors’ desire to hedge against currency depreciation. However, it is important to remember that financial assets in developing countries are more volatile than those in developed countries. This means there is a greater risk of losing money on these types of investments. Therefore, investors should always do their due diligence before making investment decisions.

Is India a New Power? Rising geopolitical tensions have led countries to become more assertive as they look to have more global influence.

On Wednesday, U.S. President Joe Biden and Indian Prime Minister Narendra Modi are set to meet in Washington to discuss ways to deepen their countries’ strategic partnership. The meeting comes as the growing friction between the U.S. and rivals China and Russia is rising. Prior to his first official visit to the White House in nine years, Prime Minister Modi stressed that the relationship between the United States and India was “tighter than ever.” Meanwhile, Washington views India as a crucial partner in its attempt to prevent China from expanding its influence throughout the Indo-Pacific region.
Despite not having the best performance so far this year, India has a lot of potential. India’s blue-chip stock index, the Nifty 50, is up 3.62% on the year, and even though this is not a bad performance, it does lag many of its Asian counterparts (as the chart below shows). That said, the country is a major target for foreign direct investment as firms look for supply chain diversification. Companies such as Apple (AAPL,$185.01), Tesla (TSLA, $274.45 ), and Google (GOOGL, $123.10) have announced a desire to set up factories in India.

(Source: Reuters)

India has been a major beneficiary of the conflict between the United States and China, particularly following Russia’s invasion of Ukraine. New Delhi has been able to leverage the conflict to its advantage by playing the two sides against each other. On the one hand, India has received weapons and oil from Russia, while on the other hand, it has maintained trade ties with the United States. India’s ability to remain neutral in the conflict has also boosted its global clout, as the country has ambitions to become a significant player on the world stage. As a result, India is well-positioned for long-term growth.

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Daily Comment (June 20, 2023)

Posted on June 20, 2023June 20, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with many China-related reports, including a recap of U.S. Secretary of State Blinken’s weekend meetings in Beijing with top Chinese officials and a new report that Beijing and Havana are negotiating to establish a joint military training base in Cuba. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a new conservative government in Finland and welcome signs that the U.S. financial markets are comfortably digesting the massive issuance of Treasury bills now that the federal debt limit has been lifted.

United States-China: In a bid to ease U.S.-China tensions, U.S. Secretary of State Blinken visited Beijing over the holiday weekend and held meetings with Foreign Minister Qin Gang, top diplomat Wang Yi, and President Xi Jinping. Afterward, both sides described the marathon talks as “candid” and “constructive.” The meetings do look like they could cool tensions, but we doubt that they will appreciably shift the overall trajectory in bilateral relations, in which U.S. leaders feel like they have to respond to China’s growing military and economic power and increasingly aggressive geopolitical stance. As we’ve written before, increased tensions are likely to further disrupt trade, investment, and technology flows, putting investors at risk.

One key goal for the U.S. was to get bilateral communications back on track to reduce the risk of miscalculation and accident as Washington and Beijing compete ever more sharply in the military, diplomatic, economic, and technological spaces. The Chinese officials emphasized their commitment to taking back control of Taiwan and demanded that the U.S. not interfere with their development strategy.
In something of a win for the U.S., the Chinese side agreed to send Qin to Washington for a reciprocal visit at an undetermined time in the future. However, they repeatedly rebuffed U.S. requests to re-establish military-to-military communications.
The results of the meeting also look set to be overshadowed by a new example of Chinese aggressiveness reported this morning. According to the Wall Street Journal, Beijing and Havana are negotiating the establishment of a joint military training base on Cuba’s northern coast. Such a base would imply that Chinese troops would be stationed less than 100 miles from Florida.
- This and other recent developments suggest Chinese officials believe that taking ever more aggressive military steps against the U.S., even at the U.S. doorstep, will scare Washington into backing off China in the Indo-Pacific region.
- Given that Republicans and Democrats in Washington share a strong and growing bipartisan sentiment that China is a threat, Beijing’s approach is ripe for miscalculation. Faced with an aggressive move such as rotating Chinese combat troops through Cuba, domestic U.S. political pressure could conceivably force the administration to act. We therefore cannot discount the risk of an outright U.S.-China military crisis at some point, along with further disruptions in bilateral economic and financial ties.
Finally, it’s useful to remember that the risks for Western businesses in China don’t all come from government action. New reporting shows Chinese consumers have also begun to shift their buying toward domestic brands, at least in part because those brands have improved their quality, service, and marketing techniques.

European Union-China: The European Commission today released a new economic security strategy that included a call for EU member states to consider restricting outbound investment into countries that could be a security risk. Although the document didn’t specifically name China as a target, it was widely interpreted as being another example of how Brussels has swung around to embrace U.S. concerns about China, even if many of the EU’s national governments are still resisting any substantial efforts to restrict trade or investment ties with Beijing.

China: Separately, Chinese officials continue to signal they plan to roll out a big economic stimulus package as the post-“Zero COVID” recovery peters out. For example, the State Council said its Friday meeting considered several new policies aimed at boosting “effective demand” in a “more powerful way.” Such policies would buttress the central bank’s interest-rate cuts last week and today’s cut in bank prime loan rates. The question is whether President Xi will be willing to unleash enough new lending and spending to really rev up the economy, since doing so would worsen the structural challenges, like high debt, that Xi wants to bring under control. Reflecting the limited policy space for stimulus, several Western financial institutions have cut their forecast for Chinese economic growth in 2023, sparking a risk-off stance in markets today.

Over the weekend, Goldman Sachs (GS, $338.31) cut its forecast for Chinese growth this year to 5.4%, compared with its earlier forecast of 6.0%.
Similarly, UBS (UBS, $20.41) cut its forecast to 5.2% from 5.7% previously.

Finland: A coalition of right-wing parties has agreed to form a government with Petteri Orpo, the leader of the conservative National Coalition Party, as prime minister. Besides the NCP, the government will include the right-wing populist Finns Party, the Swedish People’s Party, and the Christian Democratic Party. Altogether, the four parties hold 108 of the 200 seats in parliament.

U.S. Financial Markets: The Federal Reserve reported that utilization of its facility for reverse repurchase agreements, which allows money market funds to park cash with the Fed, last week fell below $2 trillion for the first time since June 2022. The drop in usage of the facility suggests money market funds have instead been buying up the large amounts of fresh U.S. Treasury bills that the government has been selling following the recent lifting of the federal debt limit.

Money market fund managers have likely been enticed by the yields of approximately 5.15% available on Treasury bills maturing in one or two months, since that beats the current repo rate of 5.05%. The bill buying by money market funds could help ease fears that high Treasury issuance to replenish government coffers might disrupt the markets.
Nevertheless, risks remain, especially as the bulk of the new Treasury issuance is still to come. If money market funds and other investors can’t digest all the new issuance, interest rates could jump to the point where they cause instability. In addition, if the Fed hikes its benchmark fed funds interest-rate target further, the reverse repo rate would also rise and might draw funds again from the money market funds and the banking system.

U.S. Defense Industry: According to data from PitchBook, venture capitalists in the U.S. have closed more than 200 defense and aerospace deals worth about $17 billion just in the first five months of 2023. That’s more than all the deals in the sector in full-year 2019, illustrating how the war in Ukraine and the prospect of higher global defense spending has heightened investor interest in military-focused startups. We continue to believe that the trends will benefit both new and mature defense industry firms going forward, especially those focused on cutting-edge technologies.

Notably, the wave of VC funding into defense startups is reportedly rivaling the activity in artificial intelligence.
We find the VC surge into defense and artificial intelligence especially notable because high interest rates have sapped dealmaking in a wide range of other sectors.

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Asset Allocation Bi-Weekly – The Great Divergence (June 20, 2023)

Posted on June 20, 2023June 15, 2023 by Amanda Ahne

by the Asset Allocation Committee | PDF

The S&P 500 is up 10% year-to-date and briefly reached the 4,200 level in late May. The recent rally in equity markets has been driven by the rise of generative artificial intelligence (AI), which has bolstered tech stocks. In fact, much of this strong performance has come from the five largest tech companies, which now account for 24.7% of the index’s value, a record high. This concentration has led some investors to fear that a bear market similar to the dot-com bubble burst of 2000 may be on the horizon. The pessimistic outlook is related to concerns that the underperformance of the broader index has generally followed previous periods of high market concentration.

The chart above shows the relative performance of the S&P 500 Market Capitalization and Equal Weight indexes over the past 30 years. During times of uncertainty, investors tend to pile into established companies with large market capitalizations. These firms are typically better positioned to weather a downturn as they have more resources and access to capital. In this environment, the Market Cap index generally outpaces its Equal Weight counterpart. However, this outperformance does not usually last long. When the market recovers, investors often go bargain hunting as the lesser names are likely to offer more value. Thus, the Equal Weight index can outperform the Market Cap index over an extended period. That said, the recent unevenness is different than in previous market rallies.

The 2020 tech rally was driven by monetary and fiscal stimulus. The Federal Reserve injected billions of dollars into the financial system, which lowered interest rates and encouraged investors to take on more risk. Additionally, many households had excess savings due to the COVID-19 pandemic stimulus, which increased the number of retail investors. Overall, tech stocks benefited as investors looked for better returns. However, the rally was not sustainable.

As the Federal Reserve began to tighten monetary policy in 2022, interest rates rose and investors became more risk-averse. This led to a sharp decline in tech stocks, which continued until early 2023, when people began to focus on the investments that Microsoft (MSFT, $346.10) had made in machine-learning company OpenAI. The investments signaled the company’s commitment to artificial intelligence and its potential to usher in a new technology wave.

The craze for AI reached new heights in May after chipmaker Nvidia (NVDA, $431.33) forecasted that strong demand for AI chips could help the company generate $110 billion in revenue in 2024. The news led to one of the biggest tech rallies in two decades as the tech-heavy Nasdaq Composite Index rose by more than 7% in May.

Analysts have compared the release of AI-related products such as ChatGPT to the advent of the internet browser, calling it a game-changer. Although still under development, the product has a wide range of potential uses, from content creation to task automation. The technology’s diverse applications have encouraged investors to purchase AI-related stocks at a premium as they are willing to pay for AI-related companies based on their future cash streams as opposed to current earnings.

Unlike the dot-com boom of the early 2000s, many of the companies developing AI technology are not startups. The major movers in AI are established tech giants, such as Microsoft, Amazon (AMZN, $126.50), Alphabet (GOOG, $124.77), Meta (META, $280.34), Baidu (BIDU, $148.19), Tencent (TCEHY, $45.55), and Alibaba (BABA, $92.13). These companies have proven track records of success, and they are unlikely to fail if the AI bubble goes bust. As a result, the recent rally in tech stocks poses significantly less risk than the internet mania of the early 2000s because the firms driving the rally are more stable and have better track records of profitability.

While the Market Cap index has outperformed recently, this outperformance is unlikely to last. Economic growth is expected to slow in the second half of the year, which could lead to a new down-leg in the market. As demand decreases, earnings will likely be negatively impacted, leading to a decline in stock prices. However, we do not expect the repricing of major tech companies to lead to a market crash. Instead, we believe other stocks within the S&P 500 will be less affected. Consequently, the Equal Weight index may recover against the Market Cap index toward the end of the year. Additionally, these companies could be very attractive once economic growth begins to pick up.

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Daily Comment (June 16, 2023)

Posted on June 16, 2023June 16, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion on how the expiration of options contracts may place downward pressure on equities. Next, we explain why equity investors are still not convinced that central banks will not cut rates this year. Lastly, we give our thoughts on the latest Bank of Japan policy decision.

Triple Witching: Markets are expected to be down today, but there is evidence that investor optimism could still lift equities higher.

After six consecutive days of gains in the S&P 500, the simultaneous expiration of stock options, index futures, and index futures derivative contracts, also known as triple witching, threatens to end the streak. Today, $4.2 billion of U.S. and European futures are set to expire, along with the quarterly expiration of index futures and the rebalancing of benchmark indexes. Although the combination of these events does not necessarily lead to a bad day for equities, it does suggest that the day will likely be faced with increased trading volume as well as heightened volatility, particularly in the final hours as investors decide whether to chase recent gains or hedge against potential losses.
An imminent recession combined with continued optimism regarding generative artificial intelligence (AI) technology may impact investor behavior today. The craze over the machine-learning algorithms has pushed the P/E ratio for the S&P 500 Communication Services and Information Technology sectors to their highest level since the start of 2022. In contrast, the P/E ratio for the Equal-Weight Index has remained relatively stable within that same period. The divergence in performance reflects investors’ expectations that the technology will allow firms to add different sources of revenue. On the flip side, economic fears are elevated as forecasters are still predicting a recession for the second half of the year.

The decision to hedge or pursue gains may come down to each investor’s recession call. If they believe that a major downturn is imminent, they may be tempted to play it safe and protect gains made for the year. If true, this could sap momentum from the current market rally. On the other hand, if market participants assume that a recession will likely be mild or averted altogether, they may be persuaded to take on additional risk in order to maximize profits. As of right now, we believe that as long as the economic conditions remain positive, equities may offer attractive opportunities for risk-tolerant investors.

Peak Rates: Investors are already looking for the exit to the tightening cycle, even as central banks signal that their job is not done.

On Thursday, the S&P 500 index rose above 4,400 for the first time since April 2022, a surprise move given that the Federal Reserve is still expected to raise interest rates by another 50 basis points and the economy may be headed for a recession. Although some of the rally can be attributed to the recent surge in generative AI technology, all sectors of the index managed to close higher. The broad performance was likely due to investor optimism that the Fed is nearing the end of its rate-hiking cycle, as it is assumed that recent data showing that consumption is slowing and jobless claims are rising may force policymakers to rethink their current strategy.
- Additionally, a labor deal to avoid a potential strike among port workers has also likely helped boost investor sentiment.
The STOXX Europe 600 Index is hovering near a monthly high, despite falling to an intraday low following hawkish comments from ECB President Christine Lagarde. Media and retail related stocks helped fuel a recovery toward the end of the trading period resulting in the index closing slightly below the previous day’s close. The rally was related to doubts that the central bank will be able to raise interest rates significantly while the economy is in recession. Last month, consumer prices rose 6.1% from the prior year, well above the central bank’s inflation target of 2%.

The strong performance of both indexes shows that investors are not confident that policymakers will be able to maintain their inflation fight during a downturn. This bias is the most prevalent in the United States where traders appear to be looking past the Fed commenting that they are serious about continuing to increase interest rates. The CME FedWatch Tool shows that some traders expect a rate cut this year. At the same time, eurozone overnight index swaps suggest that the European Central Bank will cut rates in December. This confidence could lead to sorrow if the US economy remains resilient and the eurozone economy rebounds in subsequent quarters since inflation would then be unlikely to fall to 2% before the end of the year, which could possibly lead to additional hikes.

Bank of Japan: The Bank of Japan (BOJ) continues to be the only central bank in the G10 not to tighten policy in response to elevated inflation.

The Bank of Japan has decided to keep its negative interest rates and yield-curve-control policy in place following its two-day meeting on June 14-15, 2023. Governor Kazuo Ueda remained relatively ambiguous as to when the BOJ may alter its policy, but he maintained that officials believe inflationary pressures will moderate as cost-push factors dissipate. He also noted that the group noticed a change in corporate price-setting behavior. In April 2023, Japanese headline inflation rose 4.6% from the previous year, while core inflation rose 4.1%. These figures are well above the BOJ’s target of 2%. However, Ueda said that the central bank is confident that inflation will eventually fall back to its target as the economy adjusts to higher energy prices and other cost-push factors.
The suspense over when the Bank of Japan will finally decide to remove policy stimulus has started to weigh on the Japanese yen (JPY). The currency sank to a 15-year low against the euro after the central bank announced its policy decision on Thursday. Meanwhile, the JPY traded further above 140 against the dollar, adding to concerns that the BOJ may need to intervene to protect the currency. Going into 2023, investors had speculated that the BOJ would signal an end to the ultra-accommodative monetary policy that has kept interest rates at near zero for years. However, the BOJ has so far resisted calls to tighten policy, even as other central banks have begun to raise rates in an effort to combat inflation.

Despite elevated inflation, Japanese equities have performed remarkably well to begin the year. The Nikkei 225 is up 31% for the year, drastically outpacing the S&P 500, which is only up 15%. Much has been made about the country’s corporate reforms restoring the confidence of foreign investors. However, we believe some of this performance is related to expectations that the BOJ will end its yield-curve-control policy. In our view, the BOJ will be unlikely to quickly remove this policy, but it could take small steps, such as tweaking the band on its cap on ten-year yields. As a result, we believe that a hawkish BOJ could offer support for dollar-based investors looking for foreign exposure.

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Daily Comment (June 15, 2023)

Posted on June 15, 2023June 15, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion on the Federal Reserve’s latest interest rate decision. Next, we review the latest central bank policies in the eurozone and China. Lastly, we end with why recent developments in the Middle East and Europe have caught our attention.

Skip or Pause? Fed Chair Jerome Powell is uncertain whether the central bank will pause or hike, but he is adamant that a cut is not being considered.

The Federal Reserve left rates unchanged for the first time since February 2022. On Wednesday, policymakers announced that they would hold rates at their current levels to give the group time to observe the state of the economy. In its dot plots, Fed officials signaled that they still plan to lift rates an additional 50 bps before the end of the year. Meanwhile, the summary of economic projections showed that members had revised their expectations for real GDP growth and inflation upwards but decreased their estimates of the unemployment rate. In short, the Fed officials have become more hawkish since the February meeting despite their decision to pause.
During the press conference, Fed Chair Jerome Powell downplayed the importance of the dot plots, which show the individual projections of the Federal Open Market Committee (FOMC) members for the future path of interest rates. Powell insisted that there were no discussions held about rate hikes for the July FOMC meeting. His comments led to a strong recovery in risk assets, which had dipped following the release of the hawkish dot plots. The Nasdaq 100 fell 0.8% within 20 minutes of the Fed announcement but closed the day higher by 0.7% from the previous day. The extreme swings in equities reflect investor confidence that the central bank is finished with its hiking cycle. Fixed-income securities also rallied as bondholders believed that the Fed would trigger a recession in its attempt to fight inflation.

The opposing reactions from the bond and equity markets suggest that there is still much uncertainty regarding the Fed’s future policy path. Bondholders are confident that policymakers will continue to hike rates until inflation is under control, while equity traders believe that the Fed is leaning toward holding rates at their current levels. The diverging viewpoints suggest that one of the markets may be headed for a correction. It is too early to say which market is wrong, but we are confident that recession will likely be the arbiter.

Other Central Bank News: As the European Central Bank prepares to end its hiking cycle, the People’s Bank of China eases its monetary policy.

The ECB decided to raise its deposit rate by 25 bps to 3.50%, its highest level in 22 years. During the press conference, ECB president Christine Lagarde insisted that it has no plan to end its hiking cycle anytime soon. The decision to push rates higher comes amidst concerns that inflation is still stubbornly high. The Euro Stoxx 50 index sank following the ECB’s rate decisions as investors worried that the policy would weigh on the regional bloc’s economy, which fell into recession last quarter. However, the hawkish stance did provide a bump in the euro.
In a contrasting tactic, the People’s Bank of China cut its medium-term lending facility (MLF) rate to 2.65% from 2.75%. The decrease in rates will lower borrowing costs on 237 billion CNY ($33 billion) worth of one-year loans. This move is designed to stimulate the economy as the central bank looks to encourage growth. Earlier this week, the central bank cut interest rates on the standing lending rates by 10 bps, thus pushing down overnight rates to 2.75%, the seven-day reverse repurchase rate to 1.9%, and the one-month rate to 3.75%. The announcement will likely encourage banks to reduce their lending rates over the coming weeks, which may lead to an increase in consumption.

Despite hawkish comments from the ECB, European assets may be able to benefit from a revitalized Chinese economy. As the chart above shows, European countries are becoming increasingly integrated with the Chinese economy. Germany, in particular, may be uniquely positioned to benefit from a Chinese economic recovery since China is a significant market for Germany, accounting for nearly 10% of its GDP. The majority of these sales come from German subsidiaries in China, such as Volkswagen (VWAPY, $14.14) and BASF (BASFY, $12.63). As a result, the PBOC stimulus for the Chinese economy may provide support to European equities.

Rising Uncertainty: Geopolitical risks are increasing as tensions escalate over Iran’s nuclear program, and Europe’s access to LNG is more vulnerable than originally thought.

The U.S. has been holding talks with Iran over an agreement to limit Tehran’s nuclear program. An agreement has not been reached, but it appears Washington is prepared to release billions of dollars of frozen Iranian funds and conduct a prisoner exchange. The discussions come amidst rumors that Iran has been able to enrich uranium to 60% purity, a level at which experts say has no civilian use. Israel, also considered to have nuclear capabilities, has vowed to prevent Iran from becoming a nuclear power. If the United States and Iran are unable to reach an agreement, it is possible that Israel will take military action against Iran. This would be a major escalation of tensions in the region and could lead to a broader conflict.
Meanwhile, benchmark futures for European natural gas prices spiked as high as 24% on Thursday. The price surge was in response to an announcement that the Dutch government plans to permanently shut down Europe’s biggest gas field later this year. Gas price volatility was already elevated following forecasts of hotter weather coupled with a possible pickup in Asian demand which threaten to strain global stockpiles. Uncertainty over supply and demand for natural gas raises concerns over energy availability for the winter. Consequently, this may make it harder for countries to reduce their dependency on Russian supplies due to the conflict in Ukraine.

Geopolitical risks remain one of the biggest threats to the global economy. As the chart above shows, the Economic Policy Uncertainty (EPU) index remains well above its long-term average of 100. The EPU index tracks the relative frequency at which local newspapers use words associated with economic policy uncertainty. The index has been elevated since Russia began its invasion of Ukraine and has remained high. Although the EPU index does not suggest that the financial markets will suffer, it does signal that the chances of a fat-tail event are elevated meaning investors should continue to pay close attention to ongoing geopolitical conflict.

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Weekly Energy Update (June 15, 2023)

Posted on June 15, 2023June 14, 2023 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Oil prices may be establishing a new trading range between $67 and $75 per barrel.

(Source: Barchart.com)

Commercial crude oil inventories rose 7.9 mb when compared to the forecast draw of 1.5 mb. The SPR fell 1.9 mb, putting the total build at 6.0 mb.

In the details, U.S. crude oil production was steady at 12.4 mbpd. Exports rose 0.8 mbpd, while imports were flat. Refining activity declined 2.1% to 93.7% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. After accumulating oil inventory at a rapid pace into mid-February, injections first slowed and then declined. This week’s outsized build puts inventories back at seasonal norms. The seasonal pattern would suggest that stocks should fall in the coming weeks, but the seasonal pattern has become less reliable due to export flows.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $57.11. Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

Total stockpiles peaked in 2017 and are now at levels last seen in 2002. Using total stocks since 2015, fair value is $92.53.

Market News:

The IEA released its forecast for oil demand over the next five years. The group estimates that expanding EV usage will dampen gasoline demand and thus lead to a peak in global oil demand after an almost continuous rise for 80 years.

As the above chart shows, oil demand is forecast to fall dramatically mostly due to negative growth for road transportation. We have serious doubts that this will actually occur, but oil producers, especially those beholden to shareholders, have to be aware of this forecast since it suggests that investment in new production is at risk of being stranded. Therefore, shareholders are likely to demand a shareholder return instead of investment into new production, and it appears this trend is already beginning to happen. This forecast is likely to add to bullish pressure for prices, especially if demand exceeds expectations.
Oil prices continue to mark time in the wake of the OPEC+ announcement. Our take is that the U.S. wants prices around $60 per barrel and the Saudis have a target of at least $80 per barrel. Because of this, we are sitting in a netherworld between these two price points. Worries about Chinese demand are acting as a bearish factor on prices and offsetting the supply cuts coming from OPEC+.
- We note that it’s hot in China, but so far, coal and LNG demand have been remarkably modest. This situation would suggest weak industrial activity.
- OPEC+ production fell last month, with some sources suggesting a 67 mbpd cut while others report a lesser one. In any case, we are seeing a decline in supplies.
- There are reports that the Saudis were targeting bearish oil speculators. Given the market’s reaction, that idea makes some sense. We note that each OPEC+ announcement seems to be having less of a bullish impact.
U.S. crude oil exports have been increasing, but we are starting to get close to capacity at some export facilities.
Natural gas production in the Permian Basin has hit a new record high.
There is always tension between commodity project development and environmental concerns. Oil drilling in the Amazon Delta is pitting oil drillers against environmentalists.
Much to our surprise, it looks like the U.S. will add 3.0 mb to the SPR. Of course, this injection pales in comparison to the sales over the past year. We note the Biden administration wants to purchase another 12.0 mb over this coming year.
Venezuela has suffered falling oil production for years. However, we are starting to see a slow recovery in this area. As Russian sanctions change global oil flows, the U.S. has begun easing sanctions on Caracas.

Geopolitical News:

Although Putin and Xi seem to have a close personal relationship, the geopolitics of China and Russia are often contentious. One reason is that both nations have interests in the same regions, with one area of potential conflict being Central Asia. Russia views this region as part of its “near abroad” as some of these states were part of the Soviet Union. China wants the natural resources of these nations and is making investments in a bid to improve ties. As nuclear power demand rises, China is trying to encourage the Central Asian nations to supply it with uranium. The region is rich with this material. This development is raising tensions between China and Russia.
There are reports that U.S. and Iranian negotiators have made progress in restarting the nuclear deal. We remain highly skeptical of such reports. Although corralling Iran’s nuclear program would be potentially positive, the political costs of helping Iran would be high. Also, we doubt that the incumbent administration could promise any agreement would be binding for future administrations barring an actual treaty agreement, which seems unlikely.
- The U.S. has denied having these reported talks, though that doesn’t necessarily mean they didn’t happen. Israel reported that the U.S. and Iran held talks on what might be a narrowing set of goals. At the same time, the lead Iranian negotiator has been invited to Norway for talks. Overall, we think the Europeans really want access to Iranian oil and may be trying to foster talks. As we noted above, we think the political hurdles are too high for success.
- Furthermore, the U.S. has begun to offload the Iranian oil it seized due to sanctions. If there were serious efforts being made to restart nuclear negotiations, we doubt this would be happening.
- It has been reported that Iran is sending drone parts for assembly in Russia; again, if Iran were really trying to restart talks, the U.S. wouldn’t be issuing this intelligence.
The recent dam rupture in Ukraine has been in the news but the damage done to the Tolyatti-Odesa ammonia pipeline is also important. Ammonia is one of the key building blocks in fertilizer production. This pipeline is the world’s largest but has not operated since the Russian invasion. The attack on this pipeline may make Moscow less likely to extend the grain deal. Natural gas is important to ammonia production, and the loss of this pipeline could have a minor bearish impact on European natural gas.
In the wake of SoS Blinken’s trip to the Kingdom of Saudi Arabia (KSA), Riyadh made it clear that it wants support for a civilian nuclear program. The Saudi foreign minister warned that the U.S. faces competition from other nations. The KSA is pressing for a civilian nuclear program in return for recognizing Israel.
- There are reports that the U.S. and the KSA both threatened each other after the kingdom cut oil production. It appears that recent visits were designed to repair relations.
We continue to monitor the steady flow of leaks concerning the Nord Stream Pipeline sabotage. Reports now suggest the CIA warned Ukraine not to attack the pipeline. It remains unclear who did attack the pipeline as both the U.S. and Ukraine had an incentive to destroy the structure because it more closely tied Germany to Russia. These leaks do suggest the U.S. is trying to distance itself from the attack and pin the event on Ukraine.
- In related news, Dutch intelligence also reportedly warned the U.S. that Ukraine was planning an attack on the pipeline.
Azerbaijan is making diplomatic engagements with regional powers likely in an effort to reduce the risks to oil flows.
As relations between the KSA and China improve, Chinese businesses are “streaming” to the kingdom in search of investment opportunities.
China is rapidly expanding its refining capacity and, according to the IEA, is poised to become the holder of excess refining capacity. Since there is little direct consumption of crude oil, this excess capacity will tend to narrow profit margins for refiners.
Russia has resumed oil exports to North Korea. Given that North Korea has limited capacity to pay for such oil, we suspect that Moscow is swapping oil for military equipment.
The EU is looking to ban all Russian pipeline gas imports by the end of the year. This move would most harm Hungary.

Alternative Energy/Policy News:

EV growth is projected to rise steadily in coming years, but there are serious doubts about the availability of battery metals. The dependence on China for batteries remains a major issue as well.
- It’s arguable that short-sighted U.S. policies for the battery industry helped create China’s dominance.
- Battery metals are critical to the EV transition; the lack of mining talent could boost costs in the future.
- There is a significant price war going on in China’s EV market. A major producer has cut prices, suggesting the price war is spreading.
- BYD (BYDDY, $66.39), the Chinese auto company, is poised to become the world’s largest EV producer. It specializes in low-cost vehicles and makes one for the world market that costs just over $11k. We note BYD is also building the infrastructure to manufacture sodium-ion batteries, which are much cheaper than lithium-ion batteries.
As more investment funds flow into alternatives, we continue to monitor new technological developments. Work being done on plasma drills could expand geothermal power which is nearly emissions-free.
Although nuclear power is often heralded as a solution to climate change and carbon emissions, in reality, the U.S. has allowed its uranium industry to unwind, preferring to acquire the metal from other places. When the world was considered safe for trade and investment, this policy may have made sense; it doesn’t now.
In our 2023 Geopolitical Outlook, we discussed the race for space. Part of the allure of space is the possibility of beaming electricity from orbiting solar panels that would be exposed around the clock. Although seemingly farfetched, a team at CalTech is testing such a program. Obviously, if this works it becomes a game changer for energy.
Back on Earth, the expansion of wind and solar energy is being hamstrung by the lack of grid expansion. This is why there was an interest in Congress to address permitting in the debt ceiling negotiations. Smoke is a problem, too.
Summers are becoming increasingly unpleasant for both coasts but especially for the West Coast. There have been several news items suggesting a rapid warming trend; however, this trend may be due more to non-recurring factors and may not actually signal permanent changes.

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The Case for Hard Assets: An Update (June 2023)

Posted on June 14, 2023June 13, 2023 by Amanda Ahne

by Bill O’Grady & Mark Keller | PDF

Background and Summary

Secular markets are defined as long-term trends in an asset. There are both secular bear and bull markets. In most markets, there are also cyclical bull and bear markets, often tied to the business cycle, and in some markets, there are seasonal bull and bear markets that are usually tied to annual production or consumption cycles. For example, a secular bull market in bonds is characterized by falling inflation expectations that trigger steady declines in interest rates. A secular bear market in bonds is caused by the opposite condition―rising inflation expectations which lead to consistently rising interest rates. In comparison, a cyclical bull market in bonds is often related to the business cycle and monetary policy.

In general, secular cycles tend to last a long time. Using bonds as an example, we are likely concluding a four-decade secular bull market which encompassed several cyclical cycles. The length tends to be tied to specific characteristics of each market.

Commodity markets have secular cycles as well. Commodity demand is mostly a function of economic and population growth, whereas commodity supply comes from agriculture, ranching, mining, and drilling. As this chart shows, commodity producers face a serious secular headwind—capitalist economies tend to persistently improve their efficiency in producing finished goods from raw commodities. Commodity production is also subject to steady improvement in productivity.

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