News from Tatton Investment Management: Linchpin oil price

17 June 2022

As central banks around the world were busy reasserting their authority and credibility as the guardians of monetary stability, last week's stock market wobble turned into a fully-fledged rout this week. Last week's growth concerns morphed into fears that central banks have become so determined to stop inflation from embedding itself into our thinking that they are accepting that their countermeasures of monetary tightening may actually lead to a global recession.

This must seem extraordinary to the general public, but we should not forget that the pandemic period has been like no other and therefore with very little precedent and therefore any form of playbook of how to handle the post pandemic 'hangover' period. We have now reached the point where the disease is slowly having less and less direct impacts on our lives, but have now entered the economic period which is all about the 'medicines' side effects.

We write more in-depth about the central banks changed stance and what may lie ahead for bond markets over the remainder of 2022 in the articles below.

We as individuals, and our politicians, have become used to central bankers being very effective trouble shooters. They, rather than the political class have protected us from the big economic fractures that we fear. In the UK, while the financial crisis and Brexit felt bad, the actions of the Bank of England and other central banks kept us away from the experiencing something like the 1930s depression that followed 1929's financial crisis.

We had the biggest dose of central bank medicine ever to protect us from the short term economic impact of the economic activity shutdowns that protected us from the worst of the virus. We will never know what would have happened had we not had such support. However, we can see that the medicine itself, huge monetary injections, has almost certainly contributed to global inflationary pressures in a not insignificant way (the others being the supply chain disruptions, consumers' short term preference shift for 'things', away from services and the post pandemic shortage of labour).

The Federal Open Markets Committee, the decision-making body of the US central bank raised rates by 0.75% on Wednesday to 1.5-1.75%. Others also did so - the Bank of England by 0.25% (to 1.25%), the Swiss by 0.5% to still negative 0.25%, Taiwan by 0.125%, for example.

The Bank of Japan's (BoJ) timetabled meeting produced no change. The ECB held an ad-hoc meeting to discuss the consequences for policy of their strong signal that policy rates will be raised. Now that sounds nasty but, in actual fact, compared to the rate rising central banks, ECB and BoJ provided some good news for markets.

It may seem that the world's central banks are in a synchronised tightening mode but that's not the case. Both the BoJ and the People's Bank of China are engaged in forms of easing. This week, the BoJ committed to unlimited bond purchases (effectively new quantitative easing), a stance which was reiterated at their Friday meeting. Neither Japan nor China engaged in the massive monetary easing of 2020-2021. Indeed, both have had quite anaemic monetary growth over the period. This may well be a factor in why their (and Asian) growth levels had been well below potential but now they are able to ease policy rather than tightening.

The Asian economies are significant in global growth terms and we think western markets' fearful disposition rather misses what will probably be a positive beyond their immediate shores. Both have faced cost-push pressures from the cost of oil and gas which has raised domestic prices but their inflation levels remain much lower than in the US, UK and Europe.

We talk of central bank credibility in the articles below and, again, there is good news in how the markets had anticipated the US Fed's move. While this resulted in major bond volatility in the run up to the rates decision meeting, we make the case that "long-view" real yields may be reaching a plateau if perhaps not exactly a peak. In the short term, the fact that central bank guidance is once again working, is certainly being read as central bank's having re-established their credibility as the keepers of monetary stability - which can be argued is half the battle won already.

But equity and credit markets will remain at risk of the potential for western central banks having to restrain demand even more if the energy markets' capacity (supply) continues to be constrained or even shut down. This is in some ways a notable change in the narrative, because the cost of energy is increasingly becoming the single most driver of elevated prices, after supply shortages of goods are increasingly meeting demand levels (we mentioned the developing micro chips glut last week).

Similarly on the pressure points of construction, lumber prices in the US have now been declining for over two months while other raw material markets have seen a small but marked decline in prices since May. As a result, energy prices remain the weak spot for higher risk assets and over the course of the week we have observed an increasing negative correlation between oil prices and stock market movements - as oil prices fell by more than 5% on Friday, equities in western markets had a much welcomed day up.

Perhaps oil prices are showing some signs of flatlining as traders factor in a more pessimistic demand picture but it's still supply that dominates the nearer-term moves. For Europe, natural gas imports remain most investors' biggest fears.

Thus, it was not good news that Gazprom slowed the NordStream pipeline flow to less than half of its capacity, ostensibly because of technical "compressor" problems - which supposedly cannot be replaced because of the trade sanctions. The flows through the pipelines which traverse Ukraine remain also remain low and now the usual build-up of gas storage has been halted, as the chart below shows.

The Russian leadership perhaps detects a softening of Western resolve amid economic pressures and can see their leverage growing. As such, we should be prepared for more tactical pressure, designed to delay the help for Ukraine.

Global economic data is beginning to show signs of weakening (such as today's data for US May industrial production which showed a slight decline month-on-month). That is leading to renewed worries about equity earnings growth, and it is quite probable that analysts are in the process of trimming expectations for the second half of the year as well as for this current second quarter. However, a large amount of pain has already been taken, in the form of higher long-term rates, wider credit spreads for higher risk corporate loans and equities trading at a significant discount compared to last year.

Long maturity bond yields are unlikely to shoot up further in the face of such data but credit spreads may still be vulnerable to further widening (also see our separate article about bonds and the increasing likelihood that bond investors should see less adverse market conditions over the remained of the year now). On the credit side, Revlon - the venerable cosmetics veteran went in Chapter 11 on Tuesday - and such stories do not help perceptions of credit stability. However, there are always such incidents. Investors may worry that there may be defaults around the corner but currently actual distress is still very low while many companies have substantial liquidity. Meanwhile the flow of new corporate bond issuance has not just slowed, it has become a drought, a situation which often leads to quite sharp bounces when the available returns are higher than normal.

High corporate bond yields may start to look attractive soon. We think equities may lag any bond rally initially but the rise in yields has driven the fall in valuations so potential analyst downgrades could be offset.

Meanwhile analysts have not yet embarked on downgrades. The bottom-up guidance has been mixed, but US earnings per share growth for the next twelve months has been stable around a healthy-ish 6%. In summary this tells us, that while last week's wobble did indeed turn into a rout this week, our view from last week that this is part of the post pandemic hang-over volatility rather than the onset of a major change in long term economic outlook. Except, and that has become clearer over the course of the week, if energy supply remains an issue or gets worse, then the outlook could still get worse before it gets better. On this note the near 10% drop in oil prices towards the end of the week was most welcome!