- Market now sees Fed only raising rates 4 times this year
- Bond yields fall sharply as investors seek shelter
- Oil surges above $105 and likely to test $115
As we started 2022 – I shared five charts which I felt would have a major bearing on equities this year.
At the top of the list were:
- Crude Oil; and
- US 10-Year Treasuries
The financial world remains riveted to the prices of these two assets… perhaps more than any other.
Let’s start with WTI Crude.
It ripped above $100 (higher by 10% today) on what the potential impact of further Russian sanctions (i.e. oil and gas).
And from there, what does this do the global supply / demand equation (with Russian oil around 10% of all supply)
Let’s update the weekly chart:
From mine, things are trading largely per the script here…
I have been saying we should expect crude to challenge (if not exceed) the 2011 high of $115 in the coming weeks.
However, I don’t expect crude to hold that level over the course of several months.
For example, I think the path down to around $85 to $90 will be just as swift.
If there’s one thing about a high oil price – it will hurt demand.
Econ 101: make something (anything) more expensive – expect less of it.
The diamond industry knows this rule very well.
People will tend to consume far less energy with costs this high.
They will fly less. Drive less. ”And they will have far less discretionary funds in their pocket.
What’s more, this will act as a tax.
And whilst higher oil will feed through into higher prices for most goods and services – it will also crimp people’s spending power.
From mine, the administration should be pulling every lever they have to increase supply.
However, I am not sure “politics” will allow it.
Econ 101: create more of something and expect the price to fall.
From mine, the higher the oil price goes – the more we revise the lower growth outlook.
The more tax people have to pay.
Higher taxes => lower investment => lower growth.
The question the market is trying to answer is how high and how long will “$100+” oil will last?
Investors Seek Shelter in Bonds…
The only other story bigger than oil is what we see in bond markets.
Today bonds caught another massive bid – sending yields crater.
The 10-year – which traded north of 2.0% only a few days ago – dipped below 1.70% today.
Very rarely will you see the 10-year bond yield move this fast.
This isn’t a good sign.
What we need to see are long-duration yields rising (not falling) – which is a sign of confidence from the market.
Technically we remain in a bullish trend for these yields; however I am watching the previous high from March 29 2021at 1.77%
If we close below that key high – the recent rally could be considered a ‘false break’ higher and we are likely to trade back inside the previous distribution.
This is problematic.
For example, with the Fed looking to raise short-term rates, they will be conscious of any impact to the yield curve.
In this case the US 10-year (1.74%) less the 2-year (1.36%) which equals 38 basis points.
Fortunately the US 2-year yield has also reversed sharply – indicative of a market which now thinks the Fed can no longer afford to be too aggressive with its first rate hike this month… with expectations now only for a 25 basis point hike.
A lower 10-year yield gives the Fed far less ‘wiggle room’ to be aggressive with rate hikes.
Many are now saying instead of 6 or 7 hikes this year — expect maybe 4 or 5?
The challenge for the Fed is how to balance the various macro risks (which are largely out of their control) and that of surging domestic inflation?
My feeling is they will go ‘slowly slowly’….
Best err on the side of caution.
However, that will do nothing to curb domestic inflation risks (which are only growing).
Tomorrow we will hear from Jay Powell in front of Congress.
Assuming we get a more ‘dovish’ Fed given the unknown macro risks – what does that mean for the market?
My initial reaction is it will go higher.
However, it also sends a message that the Fed is more concerned about the state of the global economy.
The Key Question for Investors…
One way to simplify some of the complexities today is this:
Where do you think the US 10-year yield will finish the year?
If you are like me – that number is below 2.25%
If that’s true – implying rates will remain deeply negative when adjusted for inflation – that is still a very conducive market for higher asset prices.
Why?
TRINA – There Really is No Alternative
Yes there are risks.
Yes there are growing uncertainties with this horrific Russian invasion (dare I call it a war).
And much like $100+ oil – we don’t know how long (or how far) inflation will go?
8%? 10%? More?
All these things are headwinds to confidence and growth.
But the reality is the market is still trading at a forward PE of around 20x in what is a negative interest rate environment in real terms.
That doesn’t mean you rush out and buy everything tomorrow.
No.
You remain extremely selective.
There are quality stocks that have been trading at multi-year discounts worth buying.
I have been taking advantage of some of the extreme volatility to pick some of these up.
Will they fall further?
Probably. I don’t know. They might drop another 10-20%.
That’s fine.
I’m still in the process of putting more cash to work.
Whilst I expect a lot more volatility in the near-term – over the long-term – strong cash flow / strong profit margin businesses look more attractive.
Slowly but surely – I have been adding to names that I’ve been patiently waiting for.
Putting it All Together…
Before I close, the one sector to watch closely at present are financials.
With the yield curve flattening… and potential credit risks rising with Russia…. banking stocks are coming back to earth.
Now, a large part of this correction was due (irrespective of the risks or the yield curve).
For example, JP Morgan (JPM) was trading at a whopping 2x book when it traded above $170.
Far too expensive.
As a rough rule of thumb – banks are valued when they trade closer to 1x book.
For JPM – that is around $80.
I don’t think you will see $80 for JPM any time soon (i.e., a dividend of 5%) – but you could see $115.
And whilst there are risks – remember that major US banks are in excellent shape.
If they have risks to Russia – they will cut their losses and move on.
But they have ample liquidity and strong balance sheets.
If you are able to pick up a bank like JPM on any panic regarding a potential “credit event” or flatter yield curve… I would be a buyer around this level.
Regards
Adrian Tout