Bad is the new good

Published at 15:44 12 Jul 2019 by . Last edited 11:18 22 Aug 2019.

There has been a fairly wide divergence between stocks and bonds, with the bond market sceptical of the optimism that has been present in the equity market since the start of the year and expressing greater fears that the economy is headed for a recession. However, since the US Federal Reserve began to signal in mid-June its intent to ease interest rates, both stocks and bonds have rallied while some pressure on the dollar has eased.

This week, Federal Reserve Chairman Jerome Powell in a congressional testimony all but guaranteed a Fed rate cut at the end of the month, with the only question left being whether the central bank will cut by 25 or 50 basis points. Expectations have now risen such that it would take an unusual outperformance in the Consumer Price Index, retail sales, or regional manufacturing surveys between now and the end-July meeting to knock the Fed off its easing course.

But Fed officials, led by Chairman Powell, clearly articulated this week that risk management in response to elevated economic uncertainty was a stronger catalyst for the Fed’s dovish tilt than below-target inflation as was being argued earlier in the year. For a long time now, investors have understood that the equity market operates on liquidity rather than on economic fundamentals and therefore a worsening economic outlook means more accommodative monetary policy. Since 2009, more accommodative monetary policy has translated into more cash for the equity market. Such is the world we live in—one where traders are hoping for poor economic data to encourage more accommodative policy from the central bank.

It might be good for risk assets that the Fed is likely to cut rates because the economic outlook is dimming, but it might not be such a good signal for the real economy. Moreover, the link between the risks to growth and the trade uncertainty is becoming increasingly awkward for central bank officials—who are supposed to be politically agnostic—to explain without criticizing. The more time passes without a ‘grand bargain’ between the US and China, the more challenging the investment environment becomes for corporates and the bigger the drag on growth prospects (for more details, see E-mail alert: US-China: Tails in the mirror may be fatter than they appear, 13 Jun 2019.). For a market which has been conditioned for the better of a year to expect a ‘grand bargain’, each delay erodes confidence that a deal will be reached.

Fig 1. S&P 500 index vs 10-yr govt bond yield Fig 2. Probability of cut in Fed interest rate
Source: Bloomberg, Energy Aspects Source: CME, Energy Aspects

Playing defence
Those hoping that central bank easing will be the ointment the economy needs to get back on a solid growth trajectory might be disappointed. Both the Fed and the People’s Bank of China (PBC) seem resigned to trying to manage the pace of the slowdown given all the uncertainty surrounding the US-China trade war, rather than trying to goose growth. In short, central banks are playing defence rather than offence.

For the Fed, there is a big difference between cutting rates—because inflation remains too low, as Fed Presidents Charles Evans and James Bullard have argued for the better part of the year—versus cutting rates as a pre-emptive move due to fears of continued slower growth. The Fed seems to believe that the prospective ‘downturn’ needs to be offset proactively with easier monetary policy, which will keep growth on a stable even if decelerating path over the next two years, which is what may be required should there be no resolution to the trade dispute.

Meanwhile, the PBC remains constrained due to domestic liquidity problems and appears resigned to merely trying to manage the pace of the slowdown versus trying to engineer a big bounce in growth. Indeed, the PBC is currently fighting a three-headed liquidity monster, which we fear could begin to dampen real activity in the coming quarters. First, liquidity in the interbank market remains extremely thin. Second, credit risk is rising in the corporate bond market and non-bank financial sector, which is choking of funding to private companies. Higher borrowing costs tighten liquidity and the potential for more debt failures looms. Finally, the tax cuts are not resulting in higher consumption across China. There has been virtually no pick-up in retail sales and corporate private investment continues to lag.

All of this is putting a greater burden on the PBC as it finds itself facilitating trade on both ends of the bond market. A priority for Chinese officials in introducing stimulus this year was to make sure that liquidity flowed to private and smaller enterprises. This is not happening, or at least not to the extent desired. Given the command nature of the Chinese system, there is very little systemic risk to the overall economy. However, it does constrain the ability of officials to stimulate. China may not be getting the boost it had hoped for.

The more the US and China kick the trade war can down the road, the more uncertainty it will breed and, at some point, the market will have to begin to price in the possibility that there is no deal to be had. The trade war has already begun to impact investment decisions as some companies try to time their purchases around expectations for tariff increases. But those have been tactical decisions rather than strategic. We have yet to see a wholesale pullback on Capex—the proverbial ‘Capex cliff’ where investors, panicked by the uncertain prospects for growth and the potential for further trade-related deterioration, completely pull back on investments. This is the Armageddon scenario for the Fed and would be the first sign of a material hit to economic growth should trade talks bog down. We will be watching the Q2 19 earnings reports (in early August) for hints that companies are pulling back on spending in a more comprehensive way, as this would affect the growth outlook materially, not just for H2 19 but also for 2020.

Coercive diplomacy, without the diplomacy
Separately, Iran’s recent decision to ‘breach’ the terms of the 2015 nuclear deal seemingly brings the potential for direct conflict closer, but both the US and Iran remain quite measured in their actions. We view these violations as ‘technical’ rather than the start of a dash for a nuclear weapon, and therefore not enough to start serious alarm bells ringing in Western capitals. French mediation efforts continue even as measured escalation persists by both the US and Iran. The problem for the US is that much like its flailing Venezuela policy, it has no plan B and believes that Iran’s recent attacks on boats and shooting down of a US drone prove that pressure is working. While both sides want to pursue a measured approach, calibrated escalation cannot continue indefinitely. There remains a high risk of a miscalculation that can easily cause events to spiral beyond control. But for the time being, this situation is more likely to be a slow simmer than a fast boil (see E-mail alert: Searching for the diplomatic off-ramp for US-Iran conflict, 11 July 2019).

The Outlook
Brent: After surging to over $2.50/b in May at expiry, prompt Brent spreads have come off in last couple of weeks with the prompt nestling into a small 30 cent per barrel backwardation. Much of that has been driven by the shutdown of the Philadelphia Energy Solutions (PES) refinery, which has released prompt North Sea and WAF barrels (see Perspectives: Non-negative outcomes, 8 July 2019). We expect this ‘weakness’ to persist for another cycle, though we need to see the full effect of the hurricane Barry bearing down on the USGC, which has already shut in 50% of Gulf of Mexico output. At the same time, contaminated Urals issues persist and will continue to boost demand for cleaner alternatives, which should be a backstop for Brent-based barrels. The bigger risk remains demand, which has so far struggled due to a slowdown in trade as well as some seasonal swings. But margins have improved in the last month, as gasoline prices continue to surprise to the upside in a move related to the PES shutdown. The gasoline strength is helping to offset some of the gasoil weakness. Even with demand underperforming, the tightness on the crude side is likely to continue to support the market, putting a firm floor under prices.

Fig 3: Brent M1-M2 spread, $/b Fig 4: Brent M1-M12 spread, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

WTI: The WTI curve continues to move into steeper backwardation. Since early June, the 12-month spread in WTI has gone from virtually flat to $2.50 backward as Cushing draws have begun in earnest. New Permian pipelines (roughly 1.7 mb/d of committed capacity) will divert volumes from Cushing through to the end of the year. While we remain structurally constructive on WTI, recent developments may stall further WTI rallies for now. WTI-Midland averaged inside the Basin tariff for July trade month and has done so again for August—until news that the EPIC pipeline failed hydrotests surfaced this week, potentially delaying the start of the line. We think the delay will be short-lived, and with incremental arbs still shut on all other West Texas pipes towards Cushing, we expect lower flows to Cushing for both July and August. Moreover, the start of the new Permian pipelines will help clean up Midland balances after August (see E-mail alert: US exports: Going the extra mile, 9 July 2019). While the new Permian pipes will take time to flow fully, we believe they will enter service on time and have the proper connectivity to reduce West Texas flows to Cushing in Q4 19, even as output growth continues (see Data Review: US Department of Energy, 10 July 2019)

Fig 5: WTI M1-M12 spread, $/b Fig 6: Midland differential to WTI, $/b
Source: Bloomberg, Energy Aspects Source: Argus Media Group, Energy Aspects

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

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