Crude Awakening

If the Fed fell asleep after it’s 25bps hike was well received by the market, they should be wide awake now!! The market seemed to shrug off the Fed’s latest increase despite it coming in the midst of a mini-banking crisis and the risk of further disrupting the entire banking industry. The narrative suggested the recent banking crisis would not only be contained, but would cause the Fed’s terminal rate to be lower than previously anticipated just a week earlier - and that the long-awaited recession will arrive sooner – forcing the Fed to start cutting rates by as early as this Summer.

Then there was a surprise announcement by OPEC to cut oil production, with oil prices spiking overnight and suddenly one of the areas of the economy cooperating in bringing inflation down might now be a catalyst for inflation expectations to reaccelerate. That would not be good news for the Fed or markets.

Oil Production Cuts

Despite forecasts for an increase in oil demand in the latter half of 2023, oil recently approached $70 per barrel for WTI crude after reaching $115 last July. Lower oil prices are not good for a kingdom that relies heavily on oil revenues to finance it’s economy, so the decision for Saudi Arabia to cut production to drive prices up shouldn’t’ be surprising in hindsight. Furthermore, OPEC’s interests are often at odds with global consumers as it relates to oil and gas prices. Consumers want lower gas prices and the Saudis want higher oil prices. It probably didn’t help either that the Saudi National Bank lost $1 billion on the Credit Suisse investment after it was acquired by UBS.

The surprise move is sure to set off a political backlash with the White House which already suggested that the production cuts are ill-advised. While many global consumers have been battling the highest level of inflation since the 1970’s, the reprieve in energy prices was a bright spot in the fight against inflation. And although gasoline prices make up a small portion of the overall Consumer Price Index, it weighs heavily on consumer sentiment because of the visibility and frequency of filling up the gas tank for us folks that still don’t have an EV. ?

Whether the $1B loss on Credit Suisse was the motivation behind the production cut is uncertain, but it nonetheless complicates the inflationary picture for the Fed. A sudden spike in oil and gas prices could lead to rising inflationary expectations, which could potentially lead to self-fulfilling behavior.

If the Fed found themselves between a rock and a hard place during their last meeting, it is very likely they will find themselves between a bigger rock and a harder hard place at the next meeting. ??

Unforeseen Circumstances

When the Fed raised rates by just 25bps last month, it was only after careful deliberation between the impact that a rate hike would have on a fragile banking system versus the potential reacceleration of inflation if it kept rates steady. The decision was heavily scrutinized by markets as the announcement neared because the Fed’s action would itself be a message to the markets.

Fast forward a couple of weeks and it seems the 25bps move was the right one. Even though the repercussions in the banking industry could linger, we believe the damage was narrowly focused on a few select banks with poor balance sheet management and the risk of a broader contagion will be slim. The focus now turns to the impact higher energy prices will have on future rate decisions.

The move by Saudi Arabia and OPEC is expected to increase oil prices by $10 according to some analysts, which in turn would likely drive up gas prices. Oil prices have risen about $7-$8 since the announcement while gas prices have only increased slightly.

The question now is how US consumers will react. A carefully watched measure of inflation is the inflation expectations index, which provides insight into the psyche of the American consumer and how they might behave given an expected change in prices. The reason why this measure is important is because it has the potential to create a self-fulfilling cycle, where consumers who expect inflation to increase will spend more now in anticipation of higher prices later, essentially creating the inflation they feared. Whether the dynamic plays out would determine whether the OPEC cuts created a more difficult inflationary environment for the Fed and other central bankers.

The Economic Impact

Despite a contained impact on the banking system, expectations for the sequence of rate hikes and the terminal rate changed dramatically after the fall of SVB, suggesting that the Fed may slow the pace of rate hikes and pivot to rate cuts sooner. The OPEC cuts complicate that narrative but does not change the palpable decrease in economic activity and the softening of the labor market, even if only slightly. ?

We still believe that small and mid-sized banks will be more forceful in pulling back lending to mitigate risk, in anticipation of a slowdown in the economy, and to get ahead of what is likely to be increased regulatory scrutiny going forward. With the increasing share of lending provided by small and mid-sized banks this pullback could expedite the economic slowdown if larger banks don’t step in to fill the gap.

Before the OPEC announcement, investors were starting to act as if the silver lining was an earlier than expected end to the Fed’s rate hiking cycle. That could now change. With the potential for higher oil prices to drive higher gasoline prices and a spike in inflationary expectations, if the downward trend in inflation does stall, the Fed will be forced to continue to hike rates aggressively and the probability of a hard landing will increase again. For now, short-term inflation expectations continue to decline and longer-term inflation expectations remain well anchored.

The Fed’s priority remains bringing down inflation, but financial conditions have tightened as a result of the banking situation which could act as an additional brake on demand and further dampen inflation even as gas prices rise again. If sticky items like Rental Rates continue to decline as expected by real-time measures such as those provided by Apartment List, Zillow, and others, the impact of higher gas prices may not matter.

Keeping a Long-Term Perspective

A recession in the US is now likely to occur sooner rather than later driven by rate hikes and a sharp pullback in overall lending. As the labor market softens, we are likely to see more job cuts, additional cost cutting, and a reassessment of capital spending. Despite the consensus view that a recession is imminent, however, we believe that certain factors suggest it could be short and shallow. In the US, a resilient consumer, excess savings, and cost cutting measures by many companies form the basis of this assessment.

As for equity markets, there is an oscillating focus on valuation levels and earnings growth estimates that will ultimately determine what direction the markets head from here. While valuations have declined since 2022, they remain slightly above the long-term average for the S&P 500, so markets aren’t cheap. On the other hand, earnings growth estimates have declined for full year 2023 and are expected to be flat compared to last year. Further lowering of earnings forecasts could cause markets to re-test lows, but estimates seem to have stabilized at current levels. Barring any negative surprises on earnings calls starting this week, investors can start looking at longer-term opportunities.

Lower rates should be an overall positive for equities and multiple expansion tends to occur before earnings recoveries. But while the US still remains the safest and most liquid global market, we also see opportunities in Non-US equities from a valuation, earnings growth, and currency perspective. As rates decline, we should see some modest price increases from fixed income as well, to go with attractive yields that were not available before the Fed’s rate hikes.

We still believe the rest of 2023 could be volatile as sensitivity to economic data remains elevated, but by the end of the Summer the clouds should begin to lift and visibility should improve for both equity and fixed income markets.

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