The Wild Card – Oil!
By David Nelson, CFA CMT
The first half of 2022 left little to cheer about. The bear market at its lows wiped out $10 Trillion in U.S. market cap. The temporary cease fire that drove stocks +4% off the lows didn’t hold as markets gave back about half those gains last week.
Year to date, Energy is still the hands down winner but came in dead last on a trailing 1-month basis.
Reversion to the mean is a powerful force. At the start of the year value and stocks generating high free cash flow yields held up best. Long duration equity led by expensive growth stocks suffered the worst declines. Recently there has been a sentiment change and with-it relative sector and asset class performance has changed as well.
At the start of the year the overriding concern was inflation and just how far the Fed would have to tighten financial conditions to slow demand. Now as that demand slows recession or at least the high probability of one becomes the bigger worry.
In that mindset there has been a subtle shift toward growth as investors desperate to find companies with pricing power have returned to some of the same names they shed earlier in the year.
Even fixed income has sounded the recession alarm. Yields have been pushing higher all year in anticipation of the Fed’s war on inflation. However, last week the yield curve flattened further as the curve from 3 Years – 30 Years retreated to month ago levels. Reversion to the mean or a signal that that the bigger worry is recession not inflation? Unknown, but another data point to keep us up at night.
The recession fears aren’t misplaced. The Atlanta Fed’s latest estimate for GDP growth in the second quarter is -2.1% on July 1, down from -1.0% on June 30. The culprit was Friday’s ISM Manufacturing and Construction Spending reports, both coming in below expectations.
While economists have been slow to raise the odds of recession and the administration says it is not inevitable, equity markets have been signaling that it is.
The good news is that down over -19% this year much of that is discounted in current equity prices. It is also important to note that we are coming down from the unsustainably high levels of last year. We overshot to the upside coming out of COVID and are likely to overshoot to the downside today.
The challenge from here will be how far the Fed needs to raise rates to snuff out inflation expectations from rising further and will there be any improvement in the fractured supply chains that have hit nearly every industry.
GM’s announcement Friday goes to the heart of the problem. The company finished the month with 247,839 in dealer inventory. However, wholesale volumes were going to be impacted by ongoing semiconductor supply shortages and as a result were forced to hold back 95,000 vehicles.
This highlights one of our biggest challenges and the need to onshore mission critical supply chains back to the United States. It isn’t just good business, it is a national security imperative.
Oil & the Black Swan
I am confident that a combination of a born-again Fed and a growing effort to shore up our manufacturing footprint will bring the results necessary to return the United States to economic growth and prosperity.
The wild card is Energy. A series of mistakes by the administration and the unintended consequences that come with it has put our energy security in doubt. Add the fact that sanctions on Russia have still not altered Putin’s behavior, the potential for significantly higher prices for crude and of course gas are a possibility.
In fact, J.P. Morgan’s commodities team headed by Natasha Keneva and Ted Hall in a note last week explored the possibility of a retaliatory move by Russia to cut production by 3 mbd. The end result would lead to $190 Brent crude. A cut of 5 mbd would lead to an intolerable $380 price tag. These are of course just projections by one team of analysts, but it is clear there is a gaping hole in our efforts to contain the Russian bear.
India and China are buying up Russian crude happy to get the discount. Over the weekend, Ukraine’s military said it had withdrawn from the eastern city of Lysychansk, hours after Russia’s defense minister said his forces had seized control of it. Runaway energy prices have the potential to create a Black Swan event.
Ukraine (January 2022) Source Wikipedia and Center for Strategic & International Studies
Despite the massive military and humanitarian aid, the war is still raging and likely to continue. The war has pulled our allies together and now NATO is about to get two new members, Sweden, and Finland. However, the lack of strategic planning in front of the invasion has laid bare NATO’s failure.
There were three possible paths prior to the conflict. First, a diplomatic approach similar to what Kennedy negotiated with Khrushchev during the Cuban Missile Crisis.
NATO membership was a known trigger for Putin. If membership for Ukraine was not going to be protected it should never have been offered.
The second was of course NATO stepping up and flooding Ukraine with military support prior to an invasion. Most of the money and hardware was given after Russian troops were well entrenched in the country.
The U.S. and NATO went with option 3. A massive set of economic sanctions designed to cripple Putin and the Russian economy along with $Billions in military and economic support for Ukraine and its people.
Initially the effort showed promise. Even corporate America got involved severing ties with Russia ending projects and business relationships established for decades. Unfortunately, there are enough bad actors in the world like India and China happy to support a brazen dictator as long as they can save a few dollars.
The next catalyst is the coming earnings season with banks kicking off the festivities next week. The disconnect between analyst estimates and stock prices has been covered in previous posts. For now, the only adjustments analysts seem to be making are to target prices all coming down in recent days to reflect market action. The ratings are the same, but targets have been adjusted to realistic levels.
Key this season will be the outlook, margins, and customer demand. The economic calendar this week is heavy with Wednesdays FOMC minutes on Wednesday and Nonfarm Payrolls on Friday.