Pushing on a string

Published at 16:18 31 May 2019 by . Last edited 11:18 22 Aug 2019.

Risk assets have continued to consolidate this week as traders try to weigh the whole range of risks before them this summer, perhaps still holding out hope for a positive outcome to the US–China trade negotiations. After rallying by 40% from January to April, Brent has now eased by some 13% off the April highs (despite still-tight physical markets). Meanwhile, the S&P, after rallying by 20% to the end of April, has fallen by 6% from its April highs. And the bond market, which never believed in the equity rally, continues to see yields compress, with the US government 10-year bond yield this week seeing its lowest close since September 2017. Japanese and German bonds revisited their 2016 lows this past week as inflation expectations have been melting away.

There are some echoes here of 2016, when the rapid decline in bond yields that summer was ignored by equities, which were on the rebound from the oil slump at the start of that year. Sound familiar? Of course, in 2016 it was predominantly Brexit and China deflation fears driving yields lower, and bonds eventually rallied with the election of Donald Trump.

This recent drop in yields is less a reflection of rising risk of recession or outright deflation, but perhaps rather a realisation that central banks may not have the tools required to boost growth and/or inflation. It is sort of like adding sugar to tea. At some point, adding more sugar no longer makes the tea taste sweeter; it only adds calories to the hips. In this way, the US Fed must truly ask itself whether cutting rates still spurs growth, adds liquidity or stokes inflation. How much more incentive can be gained by lowering the cost of money from already historically low rates? At what point does the Fed realise that maybe it only keeps pushing on a string by lowering rates, as the supply of credit is not necessarily the problem, but the demand for it instead? Lower rates are not boosting risk-taking in the real economy. In fact, some would argue the opposite: artificially low rates drive traders to take money out of risk and put it into risk-free assets, helping to perpetuate the very same distortions that central banks are trying to fix.

A Fed that remains reactive rather than proactive may seem out of step for the equity market, which increasingly relies on central bank liquidity to boost prices. Traders are now betting that the Fed will be forced to cut rates at least twice more by January 2020 and a third time by the end of next year. But the Fed dot plot is still baking in a 25 basis points hike by the end of 2020. The Fed insists that it will wait until it sees clear signs of a slowdown before moving on rates. Perhaps Trump’s latest tariff move against Mexico will be the catalyst (see E-mail alert: Tariffs on Mexico to raise heavy sour prices for USGC refiners initially, unless exemptions apply, 31 May 2019). 

Officials increasingly see, as Fed chair Jerome Powell himself has pointed directly to, trade tensions as the biggest risk to the economy. The problem for the Fed is that it is incredibly difficult to model the potential fallout from an escalation in the trade war (Goldman Sachs in its base case forecasts that a deal would lead to a 0.75-1.0 ppt boost to Capex growth relative to a scenario of further tariff escalation with China), let alone prescribe policy tools to try and fix it.

War – what is it good for?
For better or worse, the market has not yet fully priced in the potential for an escalation in the trade row, and the broad consensus remains that there will be a deal this summer at the end of this negotiation. The operative word here is ‘yet’, as we continue to believe that markets are complacent to the risk of no resolution at the G20 meeting at the end of June. The rhetoric alone, shifting from quantifiable metrics like the trade imbalance to more esoteric matters such as national security and existential threats from ‘the rise of China’, suggests that both sides are girding for a much longer negotiation which is going increasingly public.

Even US officials in Beijing admit that they have had very little guidance from the White House and have absolutely no idea what the President will do. Part of the problem is that politically, Trump absolutely loves being ‘the tough guy’ on China. It resonates well politically both with his base and across party lines. Moreover, for two years now, analysts and economists have been warning of an economic armageddon should the US embark in a trade war with China, yet equity markets have remained stable with only small pockets of volatility and have not punished the President for his policy actions. If equity markets won’t punish or temper the President, then what or who will? Of course, it also distracts from the Mueller report (NO COLLUSION!).

Worryingly, it is our understanding that there has been little prep work done for bilateral meetings between the US and China at the G20. This is in stark contrast to the meeting between the two leaders in Buenos Aires last November. But markets are still hoping that Osaka will be a redux of Buenos Aires and that bilateral meetings between the two leaders at the G20 will deliver what is needed: an opportunity for Trump and Xi to lock themselves in a room and hammer out an agreement.

It is important to remember that Buenos Aires delivered at best a ceasefire. It was not a deal; it was an agreement to stop escalating tariffs to give negotiators time to negotiate. But those negotiations have not borne fruit. At this point, maybe that is the best that can be hoped for given that Trump (and Xi) are trying to reach a comprehensive deal that includes the trade imbalance, reducing the nuclear threat on the Korean peninsula, military understandings on China’s blue water policy and its place in the South China Sea, and of course anything related to technology (not just Huawei, but any Chinese entity that collects and transmits data).

That is a lot. Previous US presidents preferred to tackle each of these issues independently and separately. The Chinese understand that once Trump leaves office, they may never get another chance to do such a comprehensive deal, and for Trump, the US elections are just around the corner. There is a clock ticking for both sides, yet it is hard to see how either can back down from their increasingly hardline positions. We struggle to find a win-win outcome.

There are a lot of great expectations for the Osaka G20 meeting, and this is why we have not seen equity values fall even further. We still think that both sides want a deal, but it is unclear if there is a pathway yet for the type of successful outcomes necessary for these types of negotiations. As we have said now for a couple of weeks, things may need to get worse before they get better. Rather than being a catalyst for a rally, the G20 could be setting up to disappoint.

A slowdown is not a recession, yet
These fears of a protracted trade war are coinciding with a growing perception that the economy is now in the latter stages of the latest business cycle, and thus the growing chorus of those who believe the global economy is inevitably heading into a recession. Bank analysts are cherry-picking and highlighting every negative data point to prove this view while ignoring positive data. While we certainly are not suggesting that the economy is doing great, as growth has materially slowed since 2017, the data remain at best mixed. While manufacturing has surely slowed, Capex has not slowed nearly as much, while current hiring, employment and wages are all holding up and, in some cases, turning positive. Again, if we were truly on the cusp of a recession, we would be seeing all of these moving into contraction territory. That is not yet the case. Since the current business cycle started back in 2010, it most definitely has not been a straight-line rally. In fact, we have had multiple slowdowns (2010–11, 2012–13 and 2016) which did not morph into recessions. It remains to be seen if this slowdown will.

For us, employment and wage metrics remain strong, and consumer confidence is still solid as well. Until those change, we are hard pressed to see a recessionary outcome in the near term. There are a few places that we are watching very closely for signs of deterioration. Higher energy prices should be expected to eventually create a higher floor for the Dallas and Kansas City Fed indices, and both manufacturing surveys are a spotlight on the parts of the economy where we would expect to see the impact of the trade headlines most vividly (energy and agriculture). But thus far, the impact has been rather muted, or rather not as bad as could be expected.

Kansas City is one of the regions complaining most loudly about the impact of tariffs and beset by heavy flooding, so one would have expected this manufacturing release to crater. But thus far it has not, with the headline only ticking down from 5 to 4, even though new orders fell from 10 to 4. The key six-month outlook sub-indices do not portent a crumbling of sentiment either, with employment expectations rising from 19 to 23 and Capex expectations up from 23 to 27. These may crack, but they have not yet.

Fig 1: KC Fed Manufacturing survey Fig 2: KC Fed six month expected survey
Source: Federal Reserve Bank of KC, Energy Aspects Source: Federal Reserve Bank of KC, Energy Aspects

The Dallas Fed manufacturing survey, as expected, fell from +2.0 to -5.3, the worst outcome since December 2018. The details were marginally better, with shipments up from 6.3 to 7.6 and employment up from 4.6 to 11.6, though new orders fell sharply from 9.8 to 2.4. The accompanying commentary predictably cites trade-related concerns, but labour market tightness continues to be at least as big an issue. Several commentators cite weather as a temporary restraint on activity, something echoed in increased delivery times and falling inventories. The outlook section remains mixed, with expectations for activity continuing their descent but expectations for Capex and hiring remaining somewhat more robust for now.  

Fig 3: Dallas Fed survey Fig 4: Dallas Fed survey
Source: Federal Reserve Bank of Dallas, Energy Aspects Source: Federal Reserve Bank of Dallas, Energy Aspects

The Conference Board Consumer Confidence survey for May was a big upside surprise with the headline up by five points in May to 134.1, right below the cycle all-time highs seen last autumn. This certainly does not signal consumer distress. While the improvement was driven equally by the current situation and expectations components, the current situation indicator has moved to an all-time high of 175.2, with the labour market differential rising by three points to a new 20-year high of 36.3%. In the 40+ year history of this survey, the labour market differential has only ever been higher between July 1999 and December 2000. The remainder of the survey evinces a lot of strength based on the combination of robust labour market confidence and rising incomes. Neither of these are indicative of a looming recession and, more importantly, the big question of trade-related uncertainty is not evident anywhere in this release. We would expect to see a material impact on consumer-related indicators when either a) there is a strong reaction in consumer goods prices or b) the stock market falls sharply, a la December 2018.

Finally, to further underscore that that the consumer is not exhibiting signs of stress, the housing market recovery continued apace in April, with new home sales down marginally m/m to 673 thousand annualised, after a big upward revision that raised March to 723 thousand annualised. The latter was a new high for the cycle, and one needs to go all the way back to October 2007 to find a higher reading. Prices continue to improve markedly in recent months as sales at all price points are now on the rise, whereas previous price gains were mostly contained in the mid-tier since new home sales bottomed out at the end of last year.

Fig 5: New home sales, SAAR k units Fig 6: Consumer confidence 6 month expectations
Source: US Census Bureau, Energy Aspects Source: Conference Board, Energy Aspects

The Outlook
Brent: Maintenance and unplanned outages in the North Sea are keeping supplies low, pushing the Dated Brent curve into an even steeper backwardation than the futures curve. Russian pipeline operator Transneft also finally admitted that some 3 Mt of Urals was affected by the organic chloride contamination (although that figure is much lower than the market consensus) and that it could take anywhere from six to eight months to clean the contamination rather than the couple of weeks initially projected, very much in line with what we have been publishing. Expiry has brought some limited relief to the prompt for both Dubai and Brent spreads, but the strength in differentials continues unabated. Talk of run cuts continues given the compression in margins and some additional unplanned refinery outages. Margins, however, have yet to benefit from this reduction in refinery runs. With Dubai spreads still strong, Middle Eastern producers are expected to keep July OSPs strong next week.

WTI: USGC premiums to WTI weakened as the discount to Brent also narrowed in the week. WTI timespreads and the WTI-Brent spread whipsawed as various pipeline and refinery outages due to the floods in the Midwest created tremendous uncertainty on Cushing balances, which should remain highly volatile. Indeed, the 0.35 mb/d Ozark pipeline, which the market feared would be offline for weeks due to an underwater leak, came back online on 29 May, swinging Cushing balances bullish again given that the inbound Pony Express pipeline remains offline. Amid weak margins and a plethora of unplanned refinery outages, refinery runs will likely continue to underperform over the coming weeks. Despite the shallow ramp-up in runs, USGC grades, with the exception of USGC sours, have remained strong as the coastal refineries continue to keep local grades bid to keep them at home. Next week may still see a Cushing build; however, pipelines will be the main driver for whether WTI spreads strengthen in the front or not (for more details, see Data Review, Department of Energy, 30 May 2019).

Fig 7: Prompt crude spreads, $/b Fig 8: WTI-Brent spread, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

Yasser Elguindi, Energy Market Strategist
+1 646 760 8100 (direct)

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