Weekly Hard Asset Insights
By David McAlvany
Energy Prices: A Potential Inflation Force Multiplier
It was a tough week and a rough month of September for US equities. The S&P 500 finished the week down 2.21%, and the month down 4.8%. A laundry list of building market and economic risks finally came together in September with enough weight to curb surging market momentum and manifest lower monthly prices.
The S&P 500’s September swoon broke a streak of seven straight positive monthly closes. Primary catalysts for the decline included: a China economic slowdown and Evergrande crisis, a US Federal Reserve on the verge of reducing the market’s monetary sugar intake, persistent inflation threatening consumers and corporate profit margins, drama in the US Congress over the debt ceiling and an increasingly cloudy outlook for future fiscal stimulus, and, most recently, an emerging global energy crisis.
News from around the world this week stoked concerns of just such a global energy crisis, and added upward pressure to energy commodities that are already surging. Oil is threatening to break above key technical levels between $75 – $80 that have acted as both major resistance and major support for the price of oil over the last 20 years. A break above $80 would threaten to take the lid off prices and open the door, technically, to a sustained higher price environment. Oil could remain elevated from $80 to well over $100 for a prolonged period of time. If such a move occurs, it would carry highly significant implications for economic growth, businesses, consumers, and global inflation. Energy was the best performing sector this past week, and energy stocks, for the first time in 30 years, were the only cohort in the S&P 500 to rise for the month.
Concerns over an aggressive and sustained oil price breakout are not just rooted in the technical charts. Late this week, Bank of America chimed in on energy markets. BofA already warned last month that surging natural gas prices, increasing international air travel, gas-to-oil switching dynamics, and a cold winter could send oil prices to $100 per barrel. According to Bloomberg, in a note out on Friday, BofA said, “…we may just be one storm away from the next macro hurricane.” The bank continued by saying, “If all these factors come together, oil prices could spike and lead to a second round of inflationary pressures around the world.” BofA also notes that a “…multiyear run up in crude oil prices is now in the cards” as a chronic underinvestment in bringing forth new oil supplies due to environmental concerns could extend a price spike out into the long term.
Oil prices are a heavyweight factor in the global economy. Many past economic recessions have been preceded by oil price spikes because the strain of high prices affects every aspect of the economy. Expensive oil is often the straw that breaks the back of economic growth. With today’s news that the Core Personal Consumption Expenditure Price Index (core PCE)—the Federal Reserve’s preferred inflation measure—is already at a 30-year high, the threat posed by an oil spike is greatly accentuated. This preexisting condition of already high inflation is one of the reasons Bank of America warns that an oil breakout could be the trigger for an inflation-induced global crisis.
As mentioned above, the US Commerce Department reported Friday that core PCE, excluding volatile food and energy prices, increased by 0.3% in August and rose 3.6% year-over-year to a fresh 30-year high. The inflation results were higher than the Dow Jones estimates for 0.2% M/M and 3.5% Y/Y increases.
In an excellent Friday interview on Bloomberg, economist Mohamed El-Arian touched on a number of important issues, including inflation. While discussing the risk of building “stagflationary winds” buffering the global economy, El-Arian said that “Today’s PCE is going to be ringing alarm bells at the Fed.” According to El-Arian, underpinning those stagflationary winds are declining global growth rates and rising inflation now seen in the U.S, Germany, and throughout the rest of Europe. El-Arian said, “Inflation isn’t going down…inflation is hot, hot at the core level…and if you do the pure statistical calculation, it’s very unlikely they [the Fed] can get to their [inflation] target.” According to El-Arian, the Fed will likely have to revise its year-end inflation target up, yet again. In his view, this will erode investor confidence and signal “that they don’t understand the inflation dynamic.”
El-Arian’s concern is sympathetic with concerns outlined in previous HAI articles last spring, highlighting the dramatic implications to a vulnerable market if the investment community developed a crisis of confidence in Federal Reserve economic management. Essentially referring to the market waking up to the Fed being wrong on “transitory” inflation, he says, “this is consequential, and the risk is…that at some point, the market challenges them. The market will not challenge them [the Fed] with purchases of $1.2B [per month of asset purchases], but the minute those are lower, people will have the courage again to short….”
Mr. El-Arian goes on to sink the knife into the notion of this inflation being transitory by providing a very sensible definition of what transitory in the case of inflation means: “… a transitory development…doesn’t change behavior…it doesn’t change wage setting behavior, it doesn’t change price setting behavior [but]…these behaviors are evolving, they are changing.” El Arian says, “companies feel more confident to increase prices because prices are going up everywhere.”
So this is the test, are behaviors changing? Recent increases of inflation expectation to high levels in the New York Federal Reserve’s survey, the long and growing numbers of companies increasing prices to keep up with rising cost pressures, and mounting pressure toward eventually higher levels of wage price increases would seem to indicate that behaviors are indeed evolving.
In last week’s HAI, we referenced Morgan Stanley Chief US Equity Strategist Mike Wilson’s two scenarios for a significant market correction. This week, discussing the inflation issues, he offered his view that what we have on our hands is a “major change” from the pre-pandemic era of long-trending disinflation to a new long-term era of trending inflation. In a Bloomberg interview, Wilson said, “it’s begun…when you see big trends change, you see a big kick-off move. That’s what we’ve seen in all the inflation indicators.” He goes on to suggest that his best guess is that at some point inflation will settle down before re-embarking on a long-term trend higher. If Bank of America’s concerns over oil prices and the energy market come to fruition, we may skip entirely Wilson’s inflation “settle down” period, and head straight to “higher.”
Despite the market selling this week, fresh economic news was not all bad. New orders for key US-made capital goods were up solidly in August. The news implies that business equipment spending is poised for another quarter of solid growth. According to the US Commerce Department on Monday, core non-defense capital goods orders, a forward indicator of business spending, increased 0.5% in August from 0.3% in July. Economists polled by Reuters had forecast a 0.4% gain. Also on the positive side, the Commerce Department announced that US personal spending growth increased by 0.8% in August from a downwardly revised 0.1% in July. The July number was previously reported as 0.3%.
Among other things, markets are an ongoing human psychology clinic. Bull market momentum and bubble dynamics can and do warp the way investors perceive risk and reward. When greed is engaged and markets continue to move higher, many diminish the risks and consider bullish market narratives to be verified by upward price action. Buying the dip on trend-line support becomes all-too-easy money. When the bold, buy-the-dip bravado is surprised to the downside and previously bulletproof rising trend lines break down, reassessments are made by startled, newly unsettled, and sober eyes. If what those eyes find when the bullish rose-colored tints are removed is an array of seriously legitimate risks, then the dip can quickly turn into a decline with legs. Last week, we asked whether market declines had unfinished business. This week, stocks continued the decline and made lower lows. On Friday, markets staged an energetic comeback, but the question over unfinished business remains.
As for weekly performance: The S&P 500 closed the week down 2.21%. Gold was up 0.38% while silver gained 0.54% on the week. Platinum lost 0.64%, while palladium was the worst performing PM, dropping 2.43%. The HUI gold miners index also fell 0.92%. The IFRA iShares US Infrastructure ETF was up modestly by 0.26% for the week. Energy commodities were higher again. WTI crude oil gained 2.57%. Natural gas surged again by 8.08% on the week. The CRB Commodity Index was up 2.25%, while copper declined by 2.24%. The Dow Jones US Real Estate Index ended the week down 1.68%, while the Dow Jones Utility Average Index lost 2.24%. The US Dollar Index broke higher this week, gaining 0.81% to close the week at 94.09. The yield on the 10-year Treasury gained 1 bps to close the week at 1.48%.
Have a great weekend!
Chief Executive Officer