Recession vs reflation

Published at 14:55 15 Nov 2019 by . Last edited 16:04 15 Nov 2019.

The big moves in risk assets this year have been driven by wildly varying perceptions that keep vacillating between recession and reflation. Last spring, following the yield curve inversion and the US Fed overtightening interest rates into the end of 2018, traders began to position for a recession. The yield curve inversion triggered a massive repositioning among portfolio managers, which drove the summer bond rally as negative convexity drew in more and more buyers of bonds, in turn driving yields lower. The narrative was that the Fed was behind the curve and was too slow to cut rates, and that global growth was stalling due to the escalation in the trade battles between the US and China. The massive capitulation in risk assets in Q4 18 only helped to reinforce these anxieties.

Of course, by August this year, that narrative had failed, and the market started to transition to a quasi-Goldilocks narrative whereby growth remained stable if slow and monetary policy remained accommodative given the lack of inflation, which would be constructive for both equities and bonds. The Fed had begun easing in late July, just as some positive signals were being sent that there might be a deal for US-China trade. Treasury yields started to rise and bonds sold off. Equities, which had flatlined over the summer, slowly started to perk up and oil found a floor. Just as the market had overshot on the negativity, it was now set to overshoot the other way. The market had started to convince itself that the Fed was going to return to quantitative easing and the focus shifted, ever so briefly, from recession to reflation. Indeed, it seems the market is positioned for just that into year-end.

But that narrative is stalling as well. Those things that have driven risk markets over the last several months are beginning to fail. Predictably, doubt has started to creep in that the US and China will be able to reach an agreement, despite President Trump’s assurances that the two were on the cusp of signing a new deal. The Fed also signalled this week that it was more or less done cutting rates for the time being unless the economy materially slows.

Fed Chairman Jay Powell’s testimony this week before congress should have left very little doubt that the central bank is now on hold. The Fed believes it has delivered enough tweaks to monetary policy to deliver on its mandate: employment and inflation. If the Fed finds itself in a situation where it needs to cut further, it will be because demand is tanking and it is afraid it will be both cutting aggressively and flirting with the zero bound once again.

Fig 1: WTI vs 200 day moving average, $/b Fig 2: Brent vs USG 10 year yield
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

But what that means for oil is harder to discern. The strength in the physical crude market—with Brent and Dubai spreads moving deeper into backwardation—continues to belie the weakness in the futures price. But it could be that this physical strength is finally starting to attract some financial flows into crude. It is undeniable that crude has found a bid in the last couple of weeks. The price of WTI has tested the 200-day moving average in each of the last 10 trading days, but failed to decisively close above it. The buying has been persistent and has taken place following weakness triggered by bearish headlines, like EIA inventory data from the last two weeks showing crude stockbuilds. But following the sell-off on the bearish news, buyers would re-emerge.

It is a bit premature to pivot to a reflationary regime just yet. The US-China trade spat, a de facto trend towards deglobalisation, is a deflationary impulse that will need to at least be contained if not wholly resolved. Another element of Jay Powell’s testimony was the clear warning shot to policy makers about the limitations of monetary policy and the clear need for fiscal policy. The Fed’s remaining reserves will be the first line of defence in the event of a recession. But if policy makers want to boost domestic demand today, and/or support the Fed in fighting a recession, then the US Congress needs to start focussing on fiscal packages.

This has all happened before
Predictably, optimism over a US-China phase 1 deal, as promised by President Trump, took a hit this week when it became clear that understanding between the US and China was somehow lost in translation over the parameters of the deal. Specifically, the US understood that its commitment would be to not implement additional tariffs, whereas China is looking for ‘rollback’ to be the operative word in relation to tariffs. China is demanding that the US reverses the tariffs, as opposed to simply freezing them. But Trump clearly wants major concessions before rolling back the tariffs, and it is not clear whether China is willing (or able) to concede them. This has all happened before, and it will happen again.

In short, neither the US nor China wants to craft an agreement that looks too favourable for the other side. China needs tariff reduction but also wants some flexibility in the event that Trump reneges on any agreement they reach temporarily. Ultimately, Beijing’s core demand remains tariff reduction and all its other offers appear to be linked to this condition. There is a risk that China, again believing that it has the upper hand in these talks given the impeachment circus in Washington and the US election looming in 2020, will overplay its hand by demanding too much. In some ways, the cancellation of the APEC meeting, which was meant to provide the venue for presidents Trump and Xi to sign the phase 1 deal, was fortuitous as it is clear that the US and China still need more time to hammer out these details.

While the US and China quibble over details, the global economy is hanging by a thread. The Chinese economy slowed further in October as industrial output, household consumption and fixed-asset investment all disappointed for the month. Moreover, China’s slowdown is spilling over to its main trading partners, particularly Japan, Korea and Australia. Trade uncertainty remains the biggest headwind this earnings season. If there is going to be any stabilisation on the growth front, there needs to be some certainty on the trade front. It is hard to see growth accelerating if the two largest economic powers remain at odds with one another.

Impeach this!
Much of the focus in Washington DC is currently on the start of the public impeachment hearings. Both parties have set their strategies and put them into motion. The Republican strategy is clear. In his opening statement Devin Nunes, the top Republican on the House Intelligence Committee, emphatically said that his party will stand behind the president and will continue to accuse Democrats of leading a partisan investigation designed to undo the results of the 2016 election. While much of the testimony during the first days was credible and powerful, Republicans argue that none of the witnesses had direct, first-hand knowledge of Trump’s conduct. Of course, the White House continues to block the questioning of any of the key participants involved in these conversations who would have such first-hand information. For Republicans, what the president did may have been unseemly, ill-advised and even immoral, but it is not enough to impeach. There is another whole week of hearings scheduled for next week, but the Democrats have thus far failed to present a smoking gun.

Dems keep groping for the centre
Perhaps more interesting than the impeachment hearings this week was the news that Michael Bloomberg and Deval Patrick have both signalled an intention to throw their hats into the Democratic primary race. This was meant to be a time when the field was narrowing, but the inability of any single candidate to grab the centrist mantle has opened the door for both to enter the race. If anything, this only further underscores the problem Democrats are having in trying to get behind a single candidate who they think can challenge Trump in 2020 (in case this whole impeachment thing does not work out). Joe Biden is still in the game, but only just, and while his numbers have been sticky, he has also failed to create any meaningful distance between himself and the other candidates and has allowed others to close the gap. The leading progressives, Elizabeth Warren and Bernie Sanders, are lurching further to the left. While Warren is gaining some national ground, the party remains concerned that most polls show her as the only candidate among the front runners losing to Trump in a general election. Meanwhile, though Pete Buttigieg is creating some buzz, his youth and inability to get any traction with African American voters is causing consternation in the party. Kamala Harris and Corey Booker have also lost some ground since the summer, at a time when Biden has been struggling. The Democrats have a problem with the centre of the party.

Bloomberg has a very long road to walk. Much of the party is wary of him given that he has shifted party affiliation in the past and, while he has tremendous name recognition in the business world, there is no clear bond between him and the rest of the party. In many ways he would be an unknown quantity for much of the party.

Former Massachusetts governor Deval Patrick could be an interesting candidate. He is a firm centrist who has pointedly taken a shot at Biden’s ‘return to normalcy’ campaign strategy, perhaps realising that half of the party does not want to return to the pre-Trump normal. He is also a close friend of Barack Obama. Patrick should be able to crank up his donor base given his corporate and financial background, and there is a belief that he can galvanise support in the African American community, where Biden has had the clear advantage.

Both candidates face an uphill climb to the nomination. Both will start with no campaign cash, little organisation and none of the polling numbers needed to qualify for a debate. This is yet another challenge, mainly for Biden. We are hard pressed to say that Biden is done, as he does have strong institutional support within the party. However, the inclusion of these two ‘business-friendly’ centrists does create another obstacle for Biden to claim the mantle of the representative of the centre of the party.

The Outlook
Brent: Brent time spreads continue to roll higher as more European and Asian refineries return from maintenance. The combination of the fresh jump in freight rates (this time mostly related to poor winter weather, which we had warned earlier), coupled with rising runs as refiners come out of maintenance, has pressured refining margins, which has made the support for flat price all the more notable in the last two weeks. Complex refining margins should worsen moving forward as refineries return from maintenance. European refineries are now buying crude for December runs, which is tightening the crude market and compressing product cracks. Asian refiners meanwhile are buying crude for January runs, which is supporting January crude differentials in the East but once again weighing on product cracks, as we highlighted in our Weekly Margins Report.

Fig 3: Dubai M1 - M3 spread, $/b Fig 4: Singapore complex refining margin $/b
Source: Argus Media Group, Energy Aspects Source: Argus Media Group, Energy Aspects

WTI: US crude stocks rose modestly last week by 2.2 mb to 449 mb, though stocks at Cushing drew by 1.2 mb and total petroleum stocks drew by 5.9 mb, bringing the total draw over the last 12 weeks to 42 mb. Exports remained weak for a second week in a row, as the surge in freight rates last month led to several November cargo cancellations. Meanwhile, Permian stocks have begun to draw, and linefill for the 0.9 mb/d Gray Oak pipeline will permanently remove 3 mb of Permian stocks. Once the line is commissioned, we expect Permian crude draws to be relentless, especially as flows on other pipelines increase due to wider arbitrage from the Permian to the USGC. Every US crude grade is now backwardated, and with US refinery runs set to increase by more than 1 mb/d by the end of November, strength in crude prices should be supported at present levels.

Cushing stocks should end the year at 37 mb at year-end. Pressure restrictions on the Keystone pipeline—which restarted on 11 November after a two-week outage—will ultimately lower Cushing stocks, but not to levels that would prevent prompt WTI-Cushing timespreads from rolling down. November cash WTI continues to trade at around a $0.10 contango, and until Cushing stocks drop below 35% of the hub’s shell capacity, WTI-Cushing timespreads will continue to expire close to flat until the new year. However, as we noted in our weekly US Department of Energy report, we expect crude output to slow materially by year-end, exports to rise to 3.5 mb/d in the weeks ahead and crude stocks—especially across PADD 3—to drop for tax reasons.

Fig 5: WTI Mar - Apr spread, $/b Fig 6: US crude stocks, mb
Source: Bloomberg, Energy Aspects Source: EIA, Energy Aspects

Yasser Elguindi 
Head of Macro Energy
+1 646 760 8100 (direct)

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