Author: Amanda Ahne

Daily Comment (February 16, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion about the possibility of a soft landing for the economy. Next, we review how the battle for semiconductors is causing friction within the U.S.-led bloc. Lastly, we give our thoughts on the recent rally in the U.S. dollar.

Soft Landing? Better-than-expected economic data in January has led to optimism that the Fed may be able to end its hiking cycle before a recession happens.

  • January was full of positive economic surprises. The employment payroll numbers nearly tripled consensus estimates. Homebuilders’ confidence surged to a four-month high. Retail sales receipts rose and blew past expectations, and manufacturing output jumped by the largest amount in nearly a year. The strong data helped bolster claims that a recession may be further away than the markets realize and suggests that the Fed may have more time to continue raising rates. As a result, the S&P 500 closed 0.3% higher on Wednesday after trailing most of the day, and the USD surged to a six-week high.
  • The strong data has forced the markets to take the Fed seriously. Fed futures swap rates indicate that investors believe there is a 63% chance that interest rates will rise at or above the Fed’s median projection range of 5.00%-5.25%. Some investors are even betting that the Fed could go as high as 6.00%. This is a sharp contrast to a few weeks ago after the comments from Fed Chair Jerome Powell led to speculation that the Fed could end its tightening cycle this June.
  • However, don’t confuse good weather with an economic recovery. January temperatures were the sixth warmest in almost 189 years, and households spent more money on outside activities causing firms to add more workers to meet the demand. Food services receipts were 25.4% higher than the previous year, while leisure and hospitality made up almost a quarter of the month’s employment gains. Additionally, much of those gains in homebuilder optimism were related to a decline in borrowing costs. Last month, mortgage rates fell to a four-month low but then rebounded in February. Therefore, we believe last month’s data showed that the recession has not been averted but merely delayed.

Chip War: Rising geopolitical risk is causing headwinds for the semiconductor industry.

  • The U.S.-led bloc is clamping down on technology transfers to its rivals. The European Union is proposing new restrictions on the exports of electronic components to Russia. The measure is aimed at curtailing Moscow’s ability to develop the weapons needed to maintain its war efforts in Ukraine. Meanwhile, semiconductor equipment maker ASML (ASML, $676.81) reported that it had found yet another Chinese spy who had stolen information about its technology. This is the second time in less than a year. The theft, along with the Russian war effort, reflects the West’s growing unease with sharing key technology with Russia and China.
  • Although the U.S.-led bloc appears to be on the same page regarding Russia, there seems to be a divide when it comes to China. European firms do not want to risk disrupting trade relations with the second-largest economy over semiconductors. For example, ASML was hesitant to agree to limit sales of its technology to China as it did not want to take the revenue hit. Although the Dutch company eventually relented, it was after much resistance. European reluctance to limit trade ties with China will make it harder for the U.S. to curb its rival’s growth in semiconductors. Hence, these restrictions could slow, but may not stop Beijing from closing the technological gap.
  • Although semiconductor firms’ stocks have been surging since September of last year, the rift between the West and its rivals may hurt industry earnings. As the chart below shows, semiconductor stocks have outperformed the S&P 500 and the NASDAQ 100 since the beginning of 2020. The increased demand for chips by firms looking to improve their technology will likely bolster sales in the future. That said, semiconductors are procyclical and are therefore vulnerable to boom-and-bust cycles. Chipmakers have been forced to cut the prices of their goods due to the glut of semiconductors. As a result, the sector may be hurt if the economy falls into recession but could rebound once demand returns.

Is The Dollar Back? The greenback has been on a hot streak since the employment data was released. However, we are not convinced that it will last.

  • After several months of decline, the USD has regained some of its strength. Much of the currency’s resurgence is related to fears that the U.S. will be tougher on fighting inflation relative to its peers. Over the last few weeks, the European Central Bank, Bank of Japan, and Bank of England have all added to speculation that they may not be willing to tighten policy further. Moderating inflation in the European Union and the United Kingdom has led to calls from policymakers that both central banks should moderate their rate hikes. Meanwhile, newly selected BOJ Governor Kazuo Ueda pushed back against speculation that he was considering ending the central bank’s ultra-accommodative monetary policy.
  • The rally in the USD may be short-lived. Although Europe has seen some cooling in price pressures, the region still lags the U.S. in its inflation fight. Therefore, it is still likely that the ECB’s rate hike in March will exceed the Fed’s. Additionally, China’s reopening will likely help support strong GDP growth in Europe over the next few months which should support the EUR. Meanwhile, the ongoing deficit battle will encourage investors to diversify some of their currency holdings away from the USD. Also, the deepening yield curve in the U.S. indicates that financial conditions are weakening, therefore raising the likelihood of a harsh recession.
  • Although the strengthening USD has hurt foreign economies, especially in emerging markets, its reversal will likely make investing overseas worthwhile. European equities remain largely undervalued, and warmer-than-expected temperatures meant that the region was able to avert a severe recession. Additionally, relatively low inflation in Southeast Asian economies and their increased exports to China should support growth within those areas. Consequently, investors may still be able to find investment opportunities abroad despite the recent strength in the greenback.

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Weekly Energy Update (February 16, 2023)

Posted on by Amanda Ahne

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

Crude oil prices appear to have based but so far have failed to break above resistance at around $80-$82 per barrel.

(Source: Barchart.com)

Crude oil inventories rose a whopping 16.3 mb compared to a 2.0 mb build forecast.  The SPR was unchanged.

In the details, U.S. crude oil production was unchanged at 12.3 mbpd.  Exports rose 0.2 mbpd, while imports declined 0.8 mbpd.  Refining activity fell 1.4% to 86.5% of capacity.

 (Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  We are accumulating oil inventory at a rapid pace, even without SPR sales (see below).  The primary culprit is low refining activity, which should pick up later this year.  The rapid rise in stockpiles, though, is a bearish factor for oil.

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, the combined storage data will again be important.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001.  Using total stocks since 2015, fair value is $95.37.

The Nord Stream Issue:  Seymour Hersh, a long-time investigative reporter, released a blockbuster allegation a few days ago, suggesting that the U.S., along with Norway, attacked the Nord Stream pipelines.  According to his report, U.S. Navy divers from the Diving and Salvage Center based in Panama placed explosives on the pipeline and were responsible for the damage.  If these allegations are true, it would create a crisis.  Arguably, this action is a casus belli and could put the U.S. and NATO into a direct conflict with Russia.  Although, before we take the report at face value, caution should be exercised.

Hersh is an 85-year-old investigative reporter who won a Pulitzer Prize in 1970 for uncovering the Mỹ Lai massacre.  However, over the years, a good bit of his reporting has been increasingly discredited.  He wrote a large piece for the London Review of Books that suggested the Obama administration’s account of the assassination of Osama bin Laden was essentially a lie.  He faced strong criticism for that report, which relied heavily on unnamed sources.  Later, he seemed to side with the Assad regime over chemical weapons, but the allegations he made were not entirely refuted either.  Our take is that Hersh, at least at one time, was an important journalist.  Over the years, though, his reporting seems to have become increasingly erratic.

As we noted, Hersh isn’t a crackpot, but likely due to his experiences in dealing with the U.S. military and intelligence agencies, he seems to have taken a position more recently that the benefit of the doubt should go to foreign interests.  Thus, there is a potential bias to his reporting.  At the same time, even though there is a notable lack of sourcing in the report, there are solid geopolitical reasons for the U.S. to want to end Nord Stream.

The age of oil has been difficult for Europe, mainly because the continent doesn’t have much oil of its own.  Although Europe is blessed with ample coal resources, the superiority of oil as an energy source meant that without secure sources of oil, European dominance of the world was in trouble.  There is a bit of production available in Romania, and of course, after oil prices spiked in the 1970s, oil was extracted from the North Sea, but Europe was never going to achieve oil and gas independence.  The European powers attempted to expand their colonial reach into the Middle East and Asia to acquire oil, but those areas proved difficult to secure.  The Dutch lost the oil in Southeast Asia to Japan during WWII.  After WWII, when the U.S. fostered independence for European colonies, Europe lost controlled access to oil in North Africa and the Middle East.  Until the early 1970s, Europe was mostly dependent on the U.S. for oil.  Not wanting to be fully dependent on Washington for energy, Europe, and especially Germany, turned to Russia.  Naturally, this reliance on Russia wasn’t popular with the U.S.  Consistently, American administrations criticized Europe for its increasing reliance on Russia oil and gas.  The Nord Stream projects were especially galling because they directly linked Russia to Germany.

Thus, the destruction of the pipelines is arguably in American interests.  That’s why this narrative will likely be hard to quash, even if the Hersh reporting is false.  It is natural to assume that if a party benefits from an event it might have had a role in causing it.  However, that is about as far as this goes.  It is quite possible that Hersh received this information from someone that would also benefit from increased tensions between the U.S. and Russia.  And since no sources are named, it may be impossible to really prove anything.

We will continue to monitor developments and reporting around this issue.  We doubt that we will see anything definitive on this in the near term, so the most likely outcome is that it won’t cause an escalation directly involving the U.S. and NATO against Russia.  But we could see “tit-for-tat” actions, such as sabotage of LNG facilities, cutting of fiber optic cables, etc.

Market News:

  • The big news this week, although maybe it shouldn’t be, is that the U.S. will sell an additional 26 mb out of the SPR. This sale was previously mandated by Congress.  Over the past couple of decades, Congress has, on occasion, used the SPR as sort of a “slush fund” to address budget issues that couldn’t be met with taxes or by borrowing.  This is a rather small sale given the scale of recent withdrawals, but the market didn’t take the news well by selling on fears of further sales from the reserve.  In fact, the administration considered canceling the sale, but doing so would have required an act of Congress, probably difficult to do in the current environment.  We don’t think this sale matters all that much, but our Twitter feed lit up with all sorts of commentary about how irresponsible the SPR sales were, and “look, they are at it again.”   We don’t disagree about the risks from earlier sales, but this one isn’t all that big of a deal.
  • The IEA is forecasting oil demand will reach a new high this year due to China’s reopening.
  • In response to the G-7 price cap, Russia announced a 0.5 mbpd oil production cut. There are two concerns beyond the obvious one that this action will lift prices. The first is that Russia may not be making this cut voluntarily but is finding that demand for its oil is falling.  Announcing a cut may be a measure to save face.  Second, cutting production is always a risky idea because once a well is shut in, in a short amount of time that production is lost without having to redrill.  Complicating matters further is that Russia was dependent on Western expertise to drill and maintain technically difficult oil fields.  Sanctions and disinvestment may lead to further output losses.  Oil prices initially rose on the report but failed to hold gains.  Oil markets are most likely worried about global recession weakening demand rather than the loss of supply.
  • China is working on an LNG deal with Qatar. As Qatar develops its North Field, it is apparently looking for long-term contracts to finance the development.
  • Although Freeport began exporting LNG this week, regulators report that the plant has systemic safety concerns.
  • The U.S. natural gas market is dealing with increased demand, especially from LNG, and rising production. However, inventory capacity is mostly fixed, meaning that price volatility is rising.  Complicating matters is that most U.S. inventory facilities are depleted gas wells where, to maintain integrity, gas is injected and withdrawn at a mostly steady pace.  This factor leads to a seasonal pattern of storage where gas is injected from April to October and withdrawn from November to March.  Storage seasonality is why price lows usually occur in January; however, if temperatures are moderate, stored gas must still come to market.  Exports come with their own set of difficulties.  Although European gas prices have declined due to mild temperatures, once the European refill season begins, export demand will likely increase.  Volatile natural gas prices will make planning difficult and could increase volatility for fertilizer and chemical prices as well.
  • We are hearing of increasing concern over the future production from the Permian Basin. In some respects, this is nothing new.  A few years ago, some analysts were sounding the alarm that drilling practices were damaging reservoirs.  Now, firms operating in the region are considering consolidation which is rational if production has peaked.
  • A growing number of long-term forecasts suggest that U.S. oil demand may be close to peaking. If true, the case for investing in future production would be hard to make. At the same time, the lack of refining investment could lead to strong margins for the foreseeable future.
  • A warming trend over the Arctic may bring much colder temperatures to Europe and North America. If it persists, it could lead to a cold spring which could delay crop planting.

 Geopolitical News:

 Alternative Energy/Policy News:

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Daily Comment (February 15, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a new forecast indicating that global oil demand is expected to rebound to a record high in 2023.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a report showing modestly cooler price inflation in the U.K., a dramatic jump in Turkish stocks, and the latest on the U.S.-China balloon saga.

Global Oil Market:  In its monthly forecast update, the International Energy Agency boosted its expectation for global oil demand in 2023 to an all-time high of 101.9 million barrels per day, up 0.2 mpbd from its previous forecast.  That would mark an increase of 2.0 mbpd, or 2.0%, from the demand of 99.9 mbpd in 2022.  The agency ascribed the increase largely to China’s decision to end its strict Zero-COVID lockdowns.

U.K. Politics:  Scottish leader Nicola Sturgeon resigned her position as first minister and as leader of the Scottish National Party today, responding to a backlash against her strategy for securing independence and a fall in her popularity over proposed gender laws.  The resignation adds to the political upheaval Britain has faced over the last year owing to a churn in the position of prime minister, rampant inflation, and a wave of public sector strikes over pay.

U.K. Economy:  The January Consumer Price Index was up just 10.1% year-over-year, coming in cooler than both the expected rise of 10.3% and the December increase of 10.5%.  British inflation is also now noticeably slower than its most recent peak of 11.1% in October.  Nevertheless, price increases remain far stronger than targeted by the Bank of England, which suggests that its policymakers will continue to hike interest rates aggressively in the near term.

Russia-Ukraine War:  The British Defense Ministry estimates that 97% of Russia’s entire army has now been deployed to Ukraine in preparation for its new offensive there, which we described in yesterday’s Comment.  The massive Russian deployment is exacerbating a disagreement in which some U.S. military officials believe that the Ukrainians should abandon the eastern city of Bakhmut to preserve forces, but some leaders in Kyiv believe it is worthwhile to attempt to hold the city. The Ukrainian officials believe that they should continue inflicting heavy losses on the Russians to prevent them from deploying more forces elsewhere along the front lines.

Turkey:  The Istanbul stock market reopened today following its shutdown in response to last week’s devastating earthquakes, and the government’s order that private pension funds increase their allocation to Turkish stocks appears to be giving the market a major boost.  So far this morning, Turkish equity prices are up some 9.7%, and are on track for their best daily performance since 2008.

Brazil:  In an interview with the Wall Street Journal, Former President Bolsonaro stated that he will return to Brazil next month to defend himself against accusations that he fomented January’s rioting at the Brazilian capitol, despite the legal risks in doing so.  He also said he would lead the conservative opposition against leftist President Lula da Silva, although he was undecided as to whether he would run for the presidency again.  In any case, Bolsonaro’s return could worsen the country’s political polarization and could potentially be a headwind for Brazilian stocks.

China-Philippines:  Philippine President Ferdinand Marcos, Jr., summoned China’s ambassador yesterday to complain about an incident last week in which a Chinese coast guard ship trained a military-grade laser on Philippine Navy sailors trying to resupply a contingent of marines at a South China Sea outpost.  The laser temporarily blinded the Philippine sailors, prompting Manila to lodge a formal protest against China earlier this week.

  • As we noted in our Comment in recent days, Marcos has recently been mending Philippine security ties with the U.S. with moves to give the U.S. more basing rights and laying the groundwork for a tripartite U.S.-Japan-Philippines security treaty.
  • The Chinese laser incident could well be meant as a warning against such a rapprochement and serve as a reminder that Beijing asserts territorial rights to much of the waters claimed by the Philippines.

U.S.-China Surveillance Balloon Crisis:  Unidentified officials have told The Washington Post that the U.S. tracked the first Chinese balloon shot down earlier this month from the time it took off from China’s Hainan Island in late January.  The balloon was evidently tracked as it passed over the U.S. territory of Guam, with its important military installations.  It then took an unusual turn northward to Alaska, possibly because it was captured by strong winds in the upper atmosphere, until southeasterly winds finally pushed it down to the U.S. mainland.

  • The pattern of events suggests there may be some credence to China’s claim that the balloon was blown off course.
  • Nevertheless, the balloon’s initial passage over Guam would still suggest that it was meant for spying.

U.S. Economy:  At an industry conference yesterday, the leaders of some of the country’s biggest banks remarked that they have been surprised by the recent resilience of the U.S. economy and now believe the country could avoid a recession.  However, we are now only at the very beginning of the period in which our various models suggest a recession could begin.  We think it remains far too early to call a “soft landing.”  In fact, it would not be surprising to us if the recession began perhaps even late in the third quarter, which means we couldn’t confirm it in the data until well into the fourth quarter.  For investors, that means there is still a heightened risk that the stock market could embark on another downward leg before starting to trend upward for good.

U.S. Regulatory Policy:  The Federal Trade Commission’s only Republican member, Christine Wilson, has announced she will resign in protest against Chair Khan’s leadership strategy and ethics.  Until Republican leaders nominate a replacement for Wilson and for the other current Republican vacancy, the move will leave the commission’s three Democratic members with a freer hand to pursue their planned intensification of antitrust and consumer protection rules.

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Daily Comment (February 14, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with two key developments in European Union economic policy, including a suggestion that the European Central Bank will tighten monetary policy more than expected and the passage of a new law that will ban the sale of gasoline-powered cars in the EU from 2035.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including NATO’s confirmation that Russia has launched its anticipated new offensive in Ukraine and signs that the Federal Reserve may also tighten monetary policy more aggressively than investors currently expect.

European Union Monetary Policy:  ECB board member and Irish Central Bank Governor Gabriel Makhlouf said the ECB may hike its benchmark short-term interest rate to more than 3.5% this year, from 2.5% currently, and won’t cut rates until at least 2024 as it fights to bring down inflation.  The statement is at odds with investors’ current expectations for the ECB’s terminal rate to stop rising at 3.5% and for rate cuts to begin later in 2023.  In response, the EUR is trading up approximately 0.3% today at $1.0761.

European Union Regulatory Policy:  The European Parliament approved a law today that would ban the sale of gasoline-powered cars in the bloc beginning in 2035, although vehicles that run on carbon-neutral fuels would still be allowed.

Russia-Ukraine War:  The North Atlantic Treaty Organization (NATO) confirmed that Russia has launched a major new offensive in eastern Ukraine, as widely expected.  The announcement came as NATO defense ministers are meeting today in Brussels to discuss the provision of further support for Ukraine, including ramping up production of ammunition and other military aid in NATO countries.  Even though the Russians have started their new offensive after spending weeks replenishing their forces with newly conscripted troops and massing equipment along the front, it appears that they have made only limited gains so far, mostly to the north of the heavily embattled city of Bakhmut.

Russia-Moldova-Ukraine:  Moldova’s pro-European President Maia Sandu said she has confirmed that Russia had tried to instigate a coup over the last year that would topple her government and replace it with a pro-Russian government.  Moldova, on Ukraine’s southwestern border, has been a target of Russia in part because it is trying to join the European Union and cooperates closely with NATO.  In an apparent abundance of caution regarding possible Russian retaliation for Sandu’s announcement, the country has shut down its airspace today.

Turkey:  One day before Istanbul’s stock exchange reopens after a shutdown caused by last week’s earthquakes, President Erdoğan’s government has ordered the country’s private pension funds to boost their holdings of Turkish stocks to support the market.  The move is likely a further effort by Erdoğan to shore up his re-election chances ahead of May’s national balloting.

  • Under the new rules, pension funds must allocate 30% of the funds the government contributes to match individual pension contributions to Turkish stocks, up from the previous requirement of 10%.
  • The pension funds will also be allowed to increase the weighting of a single stock in their portfolio to 5%, up from 1% previously.

Israel:  Yesterday, the Knesset passed Prime Minister Netanyahu’s controversial judicial reform on its first reading, prompting a mass strike, protests by tens of thousands, and expressions of concerns by key business leaders who fear it will lead to a dictatorship and be bad for business.  The proposed law, which would give parliament the right to override court decisions with a simple majority vote, still needs to pass two more readings before it becomes law.

China:  Following on our note in yesterday’s Comment that the U.S. will restrict its citizens from direct investments in certain Chinese technology firms, reports say Singapore’s sovereign wealth fund GIC has significantly slowed its investments in China-focused private equity and venture capital funds.  The pullback by GIC evidently comes after an intense internal debate over Chinese investment prospects under the authoritarian leadership of Chinese President Xi.

  • GIC is widely recognized as an astute, sophisticated investor, and it was an early adherent to the Chinese investment story. Its decision to pull back from the market is therefore an important indicator that investor sentiment toward China has deteriorated.  Indeed, beyond China’s domestic economic management, the volatile and intense geopolitical tensions between the U.S. and China (illustrated this month by the Chinese surveillance balloon crisis) raise serious questions as to whether China is truly investable anymore.
  • Nevertheless, investors do seem to believe that China is still at least tradable. New data from Refinitiv Lipper shows that global investors have poured money into Chinese stock funds for five straight weeks, bringing the year-to-date total to some $2 billion.  The new investments in China appear to be driven by bets on its dismantling of COVID-19 pandemic lockdowns.

United States-China:  The U.S. military stated it has recovered important electronic components from the suspected Chinese surveillance balloon that was shot down earlier this month off the coast of South Carolina.  According to the announcement, crews have retrieved significant debris, including all the “priority sensor and electronics pieces” as well as large sections of the payload structure.

  • That should help U.S. intelligence and counterintelligence analysts figure out exactly what information the balloon was designed to gather, how it operated, and whether it relied on any U.S. or allied technology.
  • However, U.S. and Canadian officials say they have not yet been able to retrieve debris from the other three unidentified flying objects shot down over the U.S. and Canada in the last week.

United States-Japan-Philippines:  Philippine President Ferdinand Marcos Jr. said he wants a tripartite defense treaty between the U.S., Japan, and the Philippines to supplement the individual defense deals he has recently signed with the U.S. and Japan.  According to Marcos, stronger military relations between the three countries would help keep the peace as China becomes more geopolitically assertive in the region.

  • One of Marcos’s recent deals gives the U.S. access to four additional Philippine military bases where it can conduct training, stockpile weapons, and build infrastructure to help fight a potential conflict with China. His other deal eases the Japanese military’s access to Philippine bases.
  • Marcos’s embrace of the U.S. and Japan marks a sharp reversal from the policies of Former Philippine President Duterte, who tried to distance himself from the U.S. and its alliance system.

U.S. Monetary Policy:  Fed board member Bowman said the monetary policymakers are still “far from achieving price stability,” which means they will have to keep raising interest rates and hold them at a high level for a prolonged period.  The statement underlines the view of other key Fed officials and suggests that many investors are being overly optimistic as they look for an end to rate hikes and a potential pivot to rate cuts in the near term.

U.S. Fiscal and Regulatory Policy:  Various reports say President Biden will name Fed Vice Chair Brainard as his new economic policy coordinator this week.  Brainard will replace Brian Deese as chief of the National Economic Council, which advises the president on policy and personnel decisions and coordinates policy making across executive branch agencies.  That will open up her spot on the Fed’s board of governors and remove one monetary policymaker who has been more dovish on interest rates than Chair Powell.

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Daily Comment (February 13, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a number of observations regarding China’s relations with the rest of the world, driven by the wave of Chinese surveillance balloons belatedly discovered in North American airspace (although we don’t delve into why the North American Defense Command (NORAD) can track a small sleigh and eight reindeer every Christmas but can’t seem to locate a 200-foot-high balloon).  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including improved economic forecasts for the European Union and the stock market implications of the Kansas City Chiefs’ win in the Super Bowl last night.

United States-China:  As U.S.-China tensions continue to spiral, the U.S. is set to expand its economic measures against China to include restrictions on direct investments and private equity stakes in certain Chinese technology sectors.  The new rules will add to the U.S.’s big tariffs against Chinese imports, its clampdown on data and technology transfers to China (an effort that was expanded Friday with the naming of six additional Chinese firms that will be shut off from U.S. exports due to their work on China’s surveillance balloon program), and its hurdles to investing in the publicly traded stocks of certain Chinese companies, such as those that don’t share their accounting data with U.S. regulators and those related to the Chinese military.  The restraint on direct investments and private equity will reportedly apply to Chinese sectors such as artificial intelligence and supercomputing.

  • The new rules could be issued within two months, after the Treasury Department finishes reaching out to other governments, including the EU, to ensure that they don’t rush in to provide similar financing to China after the U.S. cuts it off.
  • U.S. firms reportedly are still trying to resist the new restrictions, but the report suggests the new limitation is virtually a foregone conclusion. Of course, big U.S. technology and finance firms are among the most active private equity investors in China, and the new rules will likely cut them off from many opportunities in the country.

China-Africa:  Not only is China facing a broad economic counteroffensive from the U.S., but it is also running into pushback against its influence-building campaign in less developed countries.  A new report shows that Chinese infrastructure development loans to sub-Saharan Africa under its signature Belt and Road Initiative fell by 54% to just $7.5 billion in 2022.  The lending decline reflects both new Chinese caution after several previous loans went sour and borrower fears that China is deliberately pushing them into debt traps.

  • The ongoing pullback in BRI lending is notable, given that the program provided almost $1 trillion in infrastructure development loans primarily to developing countries over the last decade.
  • The drop in BRI lending is probably slowing China’s effort to build influence in less developed countries, but the country still has plenty of other economic carrots in the form of export opportunities, cheap imports, and direct investments. We suspect China will continue using those incentives to attempt to bring more developing countries into its evolving geopolitical and economic bloc.

China-South America:  As evidence that China’s BRI stumbles are not stopping it from trying to build alliances with less developed countries, last week, the Chinese and Brazilian central banks signed a memorandum of understanding to set up yuan-clearing arrangements in Brazil.  The deal shows how China continues attempting to establish the CNY as a reserve currency for its evolving bloc (perhaps in a digital, resource-backed form in the future).  We note that Brazilian President Lula da Silva has recently called for a free-trade agreement between China and the Mercosur economic area composed of Brazil, Argentina, Uruguay, and Paraguay.

Japan:  Investors continue trying to assess the surprise announcement that independent academic economist Kazuo Ueda will be named as the next Bank of Japan governor.  Amid concerns that Ueda may be more willing to abandon Japan’s longstanding yield-curve control and allow bond yields to rise, Japanese stocks are trading down so far this morning.  The JPY has also weakened today, apparently reflecting concerns that Ueda would still not be able to close the gap between Japan and U.S. interest rates.

European Union:  The European Commission today boosted its forecast for EU economic growth in 2023 to 0.8%, compared with an expectation of just 0.3% last November.  It lifted its forecast for the Eurozone’s growth to 0.9% from 0.3%.  In each case, the organization now believes there will be no recession this year, matching private forecasts and validating the recent outperformance in European stocks.

Germany:  The conservative Christian Democratic Union (CDU) won Berlin’s municipal elections over the weekend, dealing an embarrassing defeat to Chancellor Scholz’s center-left Social Democratic Party (SPD) and pushing it out of the city’s government for the first time in decades.  The CDU may have trouble forming a coalition capable of governing the city, but the results still illustrate how Scholz and the SPD have been politically damaged by a range of missteps over the last year.

Turkey:  Following last week’s big earthquakes and complaints about the government’s response, President Erdoğan has ordered the arrest of dozens of architects, engineers, and others potentially involved in shoddy construction that led to the building collapses.  With the death toll from the quakes now approaching 30,000, the president is apparently trying to divert attention from his government as he prepares for the elections upcoming in May.

U.S. Defense Industry:  Last week, the Defense Department released a targeted list of weapons it’s willing to purchase under long-term contracts, which defense firms argue would be necessary in order for them to invest in expanded production capacity.  The list includes weapons such as specialized air defense systems, long-range missiles, and rockets.

  • Shifting toward multi-year contracts from single-year orders is becoming a key demand of defense contractors as they bump up against factory capacity constraints in their struggle to boost output and make up for the weapons and ammunition being sent to Ukraine for its defense against Russia. Longer-term funding commitments by the Defense Department may also be needed to boost defense industry expansion as the U.S. prepares for a potential future conflict with China.
  • Nevertheless, as shown in a hearing by the House Armed Services Committee last week, multi-year contracts alone would not be a panacea for any U.S. rearmament program. Defense contractors also warn that such multi-year orders also need to include inflation adjustments.  The contractors also say their ability to surge production is being hampered by other factors, such as a lack of skilled workers and supply disruptions.
  • In any case, the increased policy debate on expanding the defense industrial base is consistent with our view that U.S. and allied defense spending is likely on a prolonged upswing that should be a boon for traditional defense contractors and the producers of dual civilian-military goods and technology.

U.S. Cryptocurrency Regulation:  The New York Department of Financial Services has ordered Paxos Trust, which issues and lists Binance’s dollar-pegged cryptocurrency, to stop creating more of its BUSD token, although it can continue redeeming the stablecoin.  The order reflects the ongoing crackdown on crypto assets in the U.S., following a year of widespread bankruptcies and other issues in the sector.

U.S. Super Bowl Indicator:  With the Kansas City Chiefs’ 38-35 win in the Super Bowl yesterday, adherents of the “Super Bowl Indicator” will be looking for a further down-leg in U.S. stock prices.  The indicator supposedly shows that a win for a team from the American Football Conference is historically associated with a bear market in stocks in the coming year.  We continue to believe that the impeding recession is the more likely reason for a potential further decline in stocks.

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Asset Allocation Bi-Weekly – Reflections on Inflation (February 13, 2023)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

[Note: There will be no accompanying podcast with this report.]

Several advisors and their clients have been asking questions about inflation, which suggests there is a degree of uncertainty surrounding the issue.  This uncertainty is understandable as inflation is a very complicated subject and, unfortunately, economic theory has oversimplified inflation to the point where it can seem mechanical.  For example, an increase in the money supply and/or strong economic growth doesn’t always lead to inflation, but theory would suggest it should.  On the other hand, sometimes these factors do lead to inflation.  In the absence of a definitive working theory of inflation, confusion shouldn’t be a surprise.

We won’t offer a definitive theory of inflation in this short report, but we will make some observations that will hopefully shed some light on the situation.  First, it’s important to have working definitions of topics.  The Consumer Price Index (CPI) measures the cost of living, while inflation measures the rate of change in the cost of living.

The chart on the left shows the CPI beginning in 1871, and the chart on the right depicts the yearly rate of change (inflation).  On both charts, we have labeled four different monetary regimes.  On the far left is the Gold Standard.  It yielded cost of living stability, and over time, the level of the index barely budged.  However, the chart on the right shows the rate of change in the index (inflation or deflation), indicating that price volatility was the main feature of the Gold Standard years.  Because the money supply was mostly fixed, industrial expansion often led to deflation.  During wars, or when new gold mines were discovered, the influx of new money or the increase in velocity (wars boost spending) led to spikes in inflation.  Note the standard deviation in this period was a whopping 7.3%.

The second regime was Bretton Woods, which was a quasi-gold standard.  The dollar was convertible to gold, and other currencies were fixed against the dollar.  In theory, this system created an anchor, with the idea that the U.S. couldn’t abuse its reserve currency position because foreigners could demand gold for their dollars.  In practice, the U.S. was only partially constrained by the restriction of gold convertibility.  Capital controls were a key feature of this era.[1]  But the advent of the Eurodollar market created a way to circumvent capital controls and accelerated the end of Bretton Woods.  Still, in terms of price and inflation control, the system led to higher, but much less volatile, inflation.

The third regime, known as the Lost Years, emerged when President Nixon ended gold convertibility.  Although the Eurodollar market was undermining the system, Nixon didn’t want to curtail fiscal spending or the Fed to trigger a recession going into the 1972 election.  The decision unmoored the dollar and convinced foreigners that the U.S. would not inflict austerity in order to protect the value of the dollar.  In other words, American policymakers would protect the domestic economy to the detriment of foreigners.[2]  The greenback entered a deep bear market, and inflation roared.  Interestingly enough, the standard deviation actually fell, suggesting that prices were rising at a steady clip.

The fourth era, which we call Fiat Credibility, is the current regime.  Paul Volcker was a key figure in this regime.  Although he is credited with bringing down inflation by forcing two recessions on the economy, perhaps his greatest contribution was that his policies signaled that the U.S. would implement austerity (at least monetary austerity) and would be willing to put the country into a deep downturn to curtail inflation.  In other words, Volcker signaled that, to bring inflation under control, the U.S. would offer some degree of protection to foreign investors.  The dollar soared, and combined with deregulation and globalization, inflation remained at bay.[3]  Monetary policy had two pillars: a defined inflation target (usually 2%) and central bank independence, both seen as necessary to implement austerity.

This history shows that low inflation isn’t the same as cost-of-living stability.  During the Gold Standard, the broad index of prices didn’t change much over time, although year-to-year the swings could be large.  The Fiat Credibility era showed that steady price increases can be tolerated.  But make no mistake about it—prices generally rise.  When Chair Greenspan was asked to define price stability, he stated that it is an inflation level low enough to where the general price level isn’t taken into consideration when making investment or purchasing decisions.  However, this isn’t cost-of-living stability; instead, it’s a pace of price increases deemed to be tolerable.

Ultimately, inflation becomes a problem when businesses and households think it’s a problem.  When inflation begins to affect purchasing and investment decisions, the very act of protecting oneself from higher future inflation creates an adverse feedback loop of ever-increasing inflation.  For example, a business estimating a project will build in an inflation estimate for materials, thereby increasing the cost to the buyer.  Consumers, seeing higher prices, begin to protect themselves by hoarding goods. Accordingly, businesses may react similarly, causing rising inventories.  Consumers will also tend to buy sooner rather than later, which can feed into demand and exacerbate inflationary pressures.

Central bankers believe that 2% inflation is tolerable, and thus, have established public targets for that rate.  However, there isn’t anything to prove that 2% inflation has this unique characteristic.  It’s just as possible that 3% might lead to the same outcome, or it’s also possible that any target rate might lead to the perception of price stability.

This chart shows the rolling five-year standard deviation of the yearly change in CPI.  We have numbered business cycles by their length in rank order.  In general, there is a tendency to see long expansions when price volatility is below 2%.  This chart suggests that the pace of price increases may matter less than the dispersion.  Note that in the Gold Standard years, recessions were common, but ultimately, what households and businesses want is the absence of recessions.  It is quite possible that the 2% target isn’t “magic”; instead, inflation stability may be the more important goal.

Sadly, in a world that is resetting supply chains, inflation volatility is much more likely.  This is because the end of the 1990-2020 period of hyper-globalization will likely lead to a steeper aggregate supply curve which means greater inflation volatility.  If so, maintaining the 2% target may be excessively costly to the economy and, in fact, may lead to more frequent recessions and higher inflation variation.

[1] This feature also allowed governments to implement high marginal tax rates on high earning households.  It was difficult to avoid taxes by shifting money abroad.

[2] Hence the famous quote, “The dollar is our currency, but it’s your problem.”

[3] That is, until recently.

 

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Daily Comment (February 10, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with Russia’s latest response to the Western price cap and sanctions. Next, the report discusses what the deepening yield curve says about the financial market. The report concludes with our thoughts on the likely new Governor of the Bank of Japan.

 Russia Retaliates: Moscow will drastically reduce its oil output in response to EU sanctions on Russian oil, and there are rumors of Russian belligerence toward a NATO ally.

  • The Kremlin will cut its oil production by 500,000 barrels a day next month. The move comes as Russia hits back at the West for implementing a price cap on its petroleum. The decision was unusual as it was done in isolation of the Organization of Petroleum Exporting Countries, although it is likely that the group was warned before the announcement. Members within OPEC may make up for the drop in production at their next meeting. However, the size of the cut and the group’s alignment with Russia makes the likelihood of a complete offset relatively low.
  • Moscow’s reaction shows that Western sanctions on its commodities are hurting its economy. The restriction has limited Russia’s ability to fund its government expenditure. The country’s current account surplus shrank by 58.2% in January, largely due to a sharp drop in export volumes. The lack of revenue from oil will make it more difficult for Russia to ramp up its war efforts in Ukraine. The pullback in production also creates the risk that some of its oil wells will permanently be idled. As a result, this drop in oil output could have a lasting effect on crude markets.
    • This may be a game of chicken. U.S. officials wagered that keeping oil prices above Russia’s break-even of $60-$70 a barrel would possibly incentivize Russia to keep production flowing despite the price cuts. Therefore, Russia’s decision to cut output may be a way for it to pressure Washington to abandon this strategy.
  • A Ukrainian newspaper reports that two missiles entered a NATO member’s airspace. The Kyiv Independent claims that two Russian Kalibr cruise missiles entered Romanian airspace after crossing the border between Ukraine and Moldova. If true, the incident could spark a direct confrontation between NATO and Russia. The incident comes a day after a journalist accused the U.S. of blowing up parts of the Nord Stream pipelines. So far, none of the major media outlets are carrying the story, and thus, there is a possibility that this may not be true.

 Bond Warning: The Treasury market has been signaling that a recession is imminent for months, and investors are worried about what that may mean for the next downturn

  • The yield-curve inversion fell to its deepest level in over 40 years. The gap between the two-year and 10-year Treasury yields widened as much as 86 bps, indicating that financial conditions are deteriorating. The spread is related to investor beliefs that the Federal Reserve will continue to raise rates until inflation is under control. Therefore, the inversion was driven by short-term interest rates rising faster than long-term rates. The underlying belief of bondholders is that the Federal Reserve will eventually win the fight against inflation.
  • The fast rise in the short end of the yield curve relative to the long end has worried equity holders. Hence, the deep inversion equities were sold off as investors feared Fed tightening could worsen a recession. The S&P 500 fell 0.9% from the previous day, and tech stocks led the decline as the NASDAQ fell 1.1% in the same period. Meanwhile, optimism that the Fed will eventually be able to curb inflation has led to a rise in the greenback. The U.S. Dollar Index (DXY) rose 0.6% on Thursday, driven mainly by the decline in the EUR.
  • Equity traders and bondholders are working from two different narratives of the war on inflation. Stock traders assume that the Fed will eventually blink and end tightening before inflation falls to its 2% target. Meanwhile, bond investors are operating on the assumption that the Fed will succeed in reducing price pressures. The winner of this debate will have an impact on portfolios. If the equity market is correct, it means that interest rates on the long end are way too low and should begin to rise to a new high. On the other hand, the S&P 500 may experience a new low if the bond market is proven correct.

The Chosen:  Haruhiko Kuroda’s successor has finally been selected; however, markets are still unsure about what this may mean for the JPY.

  • Japanese Prime Minister Fumio Kishida nominated Kazuo Ueda to take over the country’s central bank. Ueda is a professor and former Bank of Japan member. The move came as a shock to the market as it was widely expected that Deputy Governor Masayoshi Amamiya would be selected for the job. Ueda is seen as more hawkish than Amamiya, and as a result, the JPY rallied following his surprise nomination as investors speculated that he would pave the way for the end of yield-curve control.
  • Moments after his nomination, Ueda stated that the current monetary policy is appropriate. This led to a trimming of much of the gains made in the JPY and suggested that the bank may still need to finish implementing its ultra-accommodative monetary policy. That said, his remarks may have also been meant to prevent another speculative attack on the peg of its 10-year bonds. Therefore, the Bank of Japan may intervene in the bond market to ensure that the 10-year yield cap remains within the 50 bps target.
  • Rising inflation and a weaker JPY will continue to lead to expectations that the BOJ will pivot. The bank has earned a reputation as a widow maker for its willingness to clamp down on traders wanting to challenge its policies. Although it is likely safe to assume that the central bank is ready to move away from the nearly seven years of yield-curve control, they will certainly do it on their terms and not the markets. Consequently, the transition’s timing and pace will not be known for some time. However, the switch will likely lead to an increase in demand for Japanese bonds.

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Daily Comment (February 9, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Today’s Comment begins with our thoughts on a report written by Seymour Hersh concerning the explosions that damaged the Nord Stream pipelines. We next share our view on the market’s switch in sentiment regarding central bank hawkishness. Next, we discuss the dollar’s rally to start the month and whether it can be sustained. Lastly, we provide an update on geopolitical tensions between the West and its rivals.

Nord Stream 1&2:  Seymour Hersh, a long-time investigative reporter, released a blockbuster allegation overnight, suggesting that the U.S., along with Norway, attacked the Nord Stream pipelines. According to his report, U.S. Navy divers from the Diving and Salvage Center based in Panama, put explosives on the pipeline and were responsible for the damage. If these allegations are true, it would create a crisis. Arguably, this action would be a casus belli and could put the U.S/NATO into a direct conflict with Russia. Although, before we take the report at face value, caution should be exercised.

  • Hersh is an 85-year-old investigative reporter who won a Pulitzer Prize in 1970 for uncovering the Mỹ Lai massacre. However, over the years, a good bit of his reporting has been discredited. He wrote a large piece for the London Review of Books that suggested the Obama administration’s account of the assassination of Osama bin Laden was essentially a lie. He faced strong criticism for that report, which relied heavily on unnamed sources. Later, he seemed to side with the Assad regime over chemical weapons, but the allegations he made were not entirely refuted either. Our take is that Hersh, at least at one time, was an important journalist. Over the years, though, his reporting seems to have become increasingly erratic.
  • As we note, Hersh isn’t a crackpot, but over the years, likely due to his experiences in dealing with the U.S. military and intelligence agencies, he seems to have taken a position that the benefit of the doubt should go to foreign interests. Thus, there is a potential bias to his reporting. At the same time, even though there is a notable lack of sourcing in the report, there are solid geopolitical reasons for the U.S. to want to end Nord Stream.
  • The age of oil has been difficult for Europe, mainly because the continent doesn’t have much oil of its own. Although Europe is blessed with ample coal resources, the superiority of oil as an energy source meant that without secure sources of oil, European dominance of the world was in trouble. Now, there is a bit of production available in Romania, and of course, after oil prices spiked in the 1970s, oil was extracted from the North Sea, but Europe was never going to achieve oil and gas independence. The European powers attempted to expand their colonial reach into the Middle East and Asia to acquire oil, but those areas were hard to secure. The Dutch lost the oil in Southeast Asia to Japan during WWII. Britain and France struggled to secure oil resources in the Middle East and North Africa and after WWII, when the U.S. fostered independence for European colonies, Europe lost controlled access to the oil in North Africa and the Middle East. Until the early 1970s, Europe was mostly dependent on the U.S. for oil. Not wanting to be fully dependent on Washington, Europe, and especially Germany, turned to Russia for energy. Naturally, this reliance on Russia wasn’t popular with the U.S. Consistently, American administrations have criticized Europe, and especially Germany, for their increasing reliance on Russian oil and gas. The Nord Stream projects were especially galling because they directly linked Russia to Germany.
  • Thus, seeing the destruction of the pipelines, even if the Hersh reporting is false, is in American interests. That’s why this narrative will likely be hard to quash. It is natural to assume that if a party benefits from an event it might have had a role in causing it. However, that is about as far as this goes. It is quite possible that Hersh received this information from someone that would also benefit from increased tensions between the U.S. and Russia. And since no sources are named, it may not be possible to really prove anything here.
  • We will continue to monitor developments and reporting around this issue. We doubt that we will see anything definitive on this in the near term, so the most likely outcome is that it won’t cause an escalation directly involving the U.S. and NATO against Russia. But we could see “tit-for-tat” actions, such as sabotage of LNG facilities, cutting of fiber optic cables, etc.

 Not So Fast: Investors have finally begun to lose faith that central bankers are finished tightening monetary policy.

  • Central bankers have pushed back on the notion that they are finished raising rates. Several Fed officials warned investors that the central bank still needs to hike rates to contain inflation. Some policymakers hinted that the interest rates might need to go up higher than previously anticipated to prevent services inflation from becoming sticky. Similarly, European Central Bank officials attempted to temper expectations that they were backing away from their inflation fight. European Governing Council Member Klaas Knot argued that the ECB would likely hike rates 50 bps in March and continue lifting its policy rate afterward. Fellow ECB policymaker Martins Kazaks went further and insisted that the bank lift rates to a level that “significantly” restricts the economy.
  • The market responded negatively to the news that the borrowing costs would stay elevated for the foreseeable future. The S&P 500 closed lower Wednesday, with tech stocks leading the way. Meanwhile, swap rates suggest that investors are less confident that the Fed will cut rates this year, with some predicting that the central bank could actually push rates as high as 6.0%. The change in sentiment is not only related to Fed comments but also to recent data. Yesterday, a report showed that used car prices, which have been declining over the last few months, have started to rise again. Hence, there is palpable fear that talk of a pause or pivot may have been premature.
  • Investors are trained to think that the central bank will come to save the day whenever the economy falls into recession. However, this time may be different. Monetary policymakers were not dealing with elevated inflation in the previous downturns, and thus the decision to intervene in the economy was less costly. Equities could be hit pretty hard if the Fed raises rates during a recession. That said, the economy still appears to have some steam left, and if inflation falls, holders of risk assets will likely be the biggest beneficiaries.
    • Evidence suggests that much of the rise in stocks this year is related to short covering instead of investors returning to the market. The distinction is essential as options activity may not represent a broader sentiment shift.

 Will It Last? After several months of decline, the dollar has shown signs of life following concerns that the Fed may be more hawkish than its peers.

  • The U.S. Dollar Index (DXY) has been on a tear since the beginning of February. After declining 2.3% in January, the index is now up 1.6% to start the month. The bullishness for greenbacks is related to speculation that the Bank of Japan and the European Central Bank would be less hawkish than originally thought. Most of the rally is related to talk that European inflation may have peaked and that the BOJ approached Masayoshi Amamiya, a dovish candidate, to replace the outgoing Haruhiko Kuroda as central bank governor.
  • However, there are signs that the dollar’s resurgence may not last long. The re-weighting of each country’s Consumer Price Index (CPI) has played a role in the inflation story this year. For example, German inflation fell to a five-month low in January; however, much of the decline was related to statistical tweaks. Hence, it is possible that changes could have the opposite effect. Additionally, there is renewed speculation that the Prime Minister of Japan, Fumio Kishida, could select Hirohide Yamaguchi, a hawk, as the new BOJ governor. As a result, it is still too early to tell whether the dollar is headed for another upswing.
  • Much of the strong performance in international equities is related to speculation that the dollar will be in retreat for much of 2023. This view contributed to emerging market and European-related ETFs having their highest monthly net inflows in over a year in January. Meanwhile, U.S. equities have seen their first outflow since April 2022 within that same month. Although much of these flows are related to technical trends related to the dollar, better-than-expected growth in Europe and China’s reopening also played a part in the shift away from U.S. equity markets. That said, a sustained rally in the dollar, which we view as unlikely, could reverse those flows.

 Ramping Up the Pressure: The West is tightening the screws on its adversaries as the group seeks to rein in China and Russia’s geopolitical influence.

  • The U.S. and its allies are looking to provide more military assistance to Ukraine and other countries to help deter Russian aggression within the region. The U.K. and U.S. are weighing the possibility of sending fighter jets to Ukraine to help in its war efforts. Meanwhile, Washington has approved plans to sell Poland $10 billion in weapons, including 18 Himars rocket launchers. The moves are further evidence that the war in Ukraine will not only continue throughout 2023 but could, in fact, escalate.
  • Meanwhile, China continues to find itself offside with the U.S. despite earlier attempts to thaw tensions. A group of G-7 countries is considering sanctioning the Chinese companies that supplied equipment to Russia for military purposes. Also, the ongoing row over the Chinese spy balloon continues complicating efforts to improve economic ties. Secretary of State Janet Yellen and her team of Treasury officials were scheduled to travel to Beijing later this month but were forced to cancel. Although tensions will probably smooth over between the U.S. and China in the next few months, we still believe that the countries are destined to decouple in the long run.
  • Geopolitical risks remain elevated as tensions between the U.S. and China-led blocs continue to rise. The growing rift between the two sides may impact commodity prices and investment flows. Our research suggests that the U.S. will likely have the advantage in capital, whereas the China-led bloc may have the edge in energy-related goods and raw materials. This dynamic will likely lead to higher inflation in the long run. In our view, government regulation on capital and strategic manipulation of commodity prices will lead to greater inefficiencies and market volatility, thus, leading to higher prices. Hence, investing may become trickier over time.

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Weekly Energy Update (February 9, 2023)

Posted on by Amanda Ahne

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

Crude oil prices appear to have based but so far have failed to break above resistance at around $80-$82 per barrel.

(Source: Barchart.com)

Crude oil inventories rose 2.4 mb compared to a 2.0 mb build forecast.  The SPR was unchanged.

In the details, U.S. crude oil production rose 0.1 mbpd to 12.3 mbpd.  Exports fell 0.6 mbpd, while imports declined 0.2 mbpd.  Refining activity increased 2.2% to 87.9% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  Last week’s increase was contra-seasonal.  So far, crude oil inventories have been rising this year, mostly because refinery operations have been weaker than normal.  As refining activity accelerates, we would look for commercial inventory accumulation to slow.

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.  For the next few months, we expect the SPR level to remain steady, so changes in total stockpiles will be driven solely by commercial adjustments.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001.  Using total stocks since 2015, fair value is $107.07.

Summer:

We don’t usually start thinking about summer until pitchers and catchers report to spring training.  By then, the Super Bowl has been played and we are only a couple of weeks away from the kick-off of the NCAA’s “March Madness” tournament.  However, we have been watching the gasoline markets and there are some concerns lurking around the bend.

Gasoline inventories are running about 14 mb below their five-year average.  Scaled to consumption, inventories are in line with normal, but that’s only because consumption has been weak.  We are approaching the usual peak in gasoline stockpiles, since inventories usually decline as refiners clear their winter grade gasoline from surplus to prepare for summer.  If we experience the usual drop in the coming weeks, stockpiles could be lower than normal and may trigger higher prices.  High gasoline prices are politically sensitive and may trigger another round of SPR releases.

At the same time, we are in the midst of a secular drop in gasoline consumption.  The following chart shows annual miles driven by passenger cars and light trucks.  In general, the trend in miles driven rose steadily from the early 1970s until the Great Financial Crisis in 2007.  We use gray bars to highlight periods when we did not hit a new high in the number of miles driven and note the number of months until a new peak occurred.  There was a small dip from 1973 to 1975, which was a product of the Arab Oil Embargo (which pushed up gasoline prices), and a more notable dip in the uptrend from 1979 to 1982, triggered by two U.S. recessions and a spike in prices caused by the disruptions from the Iran/Iraq War.  From 1983 until 2007, the rise in driving was relentlessly higher, with only short interruptions typically due to recessions or periods of high prices.  After 2007, though, we had a long gap before a new high was reached and the underlying trend clearly declined.

There are likely multiple reasons for the overall change in trend.  First, social media has led to friends being able to interact online, rather than needing to drive to meet in person.  Working from home and increased urbanization have also likely played a role.  Driving less, coupled with steady efficiency improvements, is leading to lower demand for gasoline.

The underlying factors reduce the chances of a gasoline crisis this summer, although the lack of inventory bears watching.  Probably the biggest factor that could push gasoline prices higher is crude oil pricing.

Market News:

  • The tragic earthquake in Turkey has closed the Ceyhan oil export terminal in southern Turkey. The terminal moves about 1.0 mbpd, with two-thirds coming from Azerbaijan and one-third from Iraqi Kurdistan.  Coupled with news that the KSA increased prices to Asia, oil markets were supported this week.  We do note that the port of Ceyhan has reopened, but it’s unclear just how long it will take for oil flows to resume.
  • The IEA has released its annual report on electricity. The report suggests that carbon emissions from electricity are trending lower as wind, solar, and nuclear power expand.
  • As we have noted in earlier reports, the Biden administration has approved a drilling project in Alaska over the objections of environmentalists. Although the president campaigned on restricting drilling activity on federal lands, he has found that the courts have not sided with this goal.  At the same time, high oil prices tend to soften opposition, so we do expect this project to go forward.
    • The administration has been struggling with dissonant objectives on crude oil production. On the one hand, the White House tends to criticize oil companies for not increasing output to quell oil prices, but then on the other it talks about a possible windfall profits tax, which would tend to reduce the incentive for investment.
    • This is not just a U.S. issue. EU climate goals, which hope to reduce natural gas imports, are stifling investment in U.S. production and LNG capacity.  It may be adversely affecting investment in the Middle East as well.  The Qatari energy minister mused recently that the EU will eventually return to buying Russian gas.  If that is the expectation, it is foolhardy to expand capacity.
  • The EIA is projecting record U.S. crude oil production (on an annual average basis) this year and next, although the growth rate is rather modest (0.1 mbpd this year and 0.4 mbpd in 2024). Much of that production is coming from the Permian Basin.
  • Japan is trying to cut coal import costs by burning lower grade coal (which is almost certainly dirtier).
  • Colombia’s President Petro made it clear during his campaign that he wanted to curtail the country’s oil and gas industry for climate change reasons. He has moved to ban oil exploration, a risky decision given that crude oil exports accounted for 34% of Colombia’s exports (excluding illegal substances).  Because oil is a depleting asset, cutting exploration will lead to falling output in the coming months.  Not only will this move hurt Colombia’s economy, it could also reduce global oil supplies.
  • Asian oil imports hit a new record in January, and that has occurred before the full effects of China’s reopening have been felt.
  • Oil and product prices have been stable recently, but much of that improvement is tied to a mild winter, which has reduced demand. Europe remains short of diesel, so prices could rise in the spring.
  • Despite the recent drop in natural gas prices, fertilizer supplies remain tight and could lead to widespread grain shortages.

 Geopolitical News:

 Alternative Energy/Policy News:

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