Energy Reality vs. Goldilocks Fantasy
As HAI has described several times, the Fed is trapped. Inflation hasn’t given the monetary maestros credible cause to abandon higher interest rate policy, and now high energy prices are freezing the Fed into a losing position. Make no mistake, higher for longer is a major problem for the consumer, many corporates, the economy, and asset prices—full stop.
If a higher-for-longer policy remains in place, it will almost certainly deliver (on a long and variable lag) hard-landing consequences to vulnerable consumers and corporates alike. When that initial weakness begins to spread throughout the economy, the dominoes will begin to fall. Eventually, the key domino, the labor market, will likely topple into contraction, at which point, our expected hard landing will manifest.
Our current “goldilocks” environment (the name given to the supposedly perfect balance of present economic factors) is facing the stiff headwinds of higher energy prices, ongoing inflation, higher interest rates, a strong dollar, and growing signs of a rapidly weakening consumer.
In fact, just this week, an update to the U.S. national economic accounts revised away a full $1.1 trillion of U.S. household savings previously assumed to have been accumulated over the past six years. Even before the negative household savings revision, JPMorgan (and countless others) had concluded that excess savings, the supposed lifeline of the consumer, have already been completely spent. In a related revision this week, U.S. personal consumption for the second quarter was more than halved from an initial 1.7% to the much weaker figure of 0.8%. The joke is gaining traction among those following the data that claims of a “strong” economy now come with an expiration date. Strength lasts only until data revisions erase it, leaving weakness in its wake.
For the consumer, however, it’s no joking matter. JPMorgan consumer trader Brian Heavey took a hammer to the myth of a “resurgent” US consumer in a note to clients: “Sentiment is quickly turning very negative across retail/discretionary (seeing weakness across retail, casual diners, casinos, etc.). What’s driving it? While the continued spike in crude is getting the most attention, we’ve anecdotally heard that data across the complex is beginning to roll as the Back-to-School tailwind fades…and [is replaced by] a renewed focus on the myriad of consumer headwinds: longer term impact of inflation/higher-for-longer rates, student debt repayment, and consumer personal savings depletion.”
This week’s Conference Board report on consumer confidence confirmed the concerns outlined by Heavey. Consumer confidence fell more than expected to a four-month low, and is now clearly reversing the gains that accompanied early 2023 stock market optimism and subsequent soft-landing enthusiasm. In the latest update, consumers’ six-month outlook dropped to the lowest levels since May with a 73.7 score. In Conference Board historical data, any reading below 80 signals a recession within one year. Crucially, in the report, survey respondents showed a notable uptick in concerns over both personal finances and their employment prospects. In highlighting specific concerns over both rising prices and rising interest rates, respondents didn’t mention merely inconvenient discretionary spending constraints, they disproportionately highlighted concerns over the core essentials—gas, groceries, and home prices.
Higher for longer is a reality, and so, too, is the weakening consumer in a 70% consumer spending-driven economy. Again, once the sequence of falling dominoes reaches the key labor market domino and it topples, the negative recessionary feedback loop begins. In such a vicious cycle, a weakening consumer drives job losses, which further drive a weakening consumer. Under the right conditions, some consumer relief could come from lower energy prices and their amplified impact on overall inflation. Unfortunately, we don’t have those “right” conditions now.
This Friday was the last trading day in September. As advertised, September lived up to its billing as the year’s weakest month historically. All major stock indexes and most S&P sectors fell during the month. The one notable exception to this sea of red was energy, which ended the month in positive territory.
Energy leadership doesn’t bode well for consumers or the markets. Interestingly, broad energy leadership and oil price outperformance late in the economic cycle is a phenomenon highly correlated with hard landings in both stocks and the economy. Conversely, soft landings are highly correlated with a broad-based easing in energy prices. This time isn’t likely to be different, and when it comes to energy, we aren’t seeing the easing.
Energy market strength keeps inflation sticky and the Fed inescapably trapped in the current higher-for-longer regime. Those facts along with a rapidly weakening consumer likely keep the U.S.S. “Economy” steaming for a recessionary iceberg. Unless higher energy prices and inflation give way along with a reversal lower in the dollar, we will likely remain on a course for iceberg impact. That could change if something else breaks before collision and the Fed is given an excuse to attempt course alteration by emergency measure.
With energy prices at the center of so many crucial global macro developments, recent HAIs have focused on the many oil market dynamics stimulating higher prices. Central to the case have been a U.S. strategic petroleum reserve at 40-year lows, Saudi and Russian production cut extensions in a market the IEA warned is in a “significant supply shortfall” of 1.2 million barrels a day, and the recent curve ball that U.S. shale’s production is rolling over now that the Permian Basin (the one bright spot for shale production as recently as early summer) is now in decline. This week, however, more tinder was added to the global energy price fire, and by extension to the inflation problem and ultimately to the higher-for-longer problem.
Russian energy companies have long been undercompensated for fuel products sold on the domestic market. This dynamic caused Russian firms to focus primarily on more lucrative export opportunities. As a consequence, Russia is now facing oil product shortages on the domestic Russian market that started in Crimea and have since spread throughout southern Russia. In response to growing shortages, Moscow intervened this week and banned exports of diesel and most gasoline until further notice. Russia makes up about 15% of the international seaborne diesel market (gas exports are lower), and those exports just dropped to zero overnight. According to UBS Group, any longstanding ban would have “big implications” for global fuel supplies at just the wrong time. The global energy situation is already precarious. Supply is tight, vulnerable, and disproportionately in the hands of OPEC+. Now, losing 15% of the international diesel supply risks putting the match to the powder keg.
Also of concern, time spreads in the oil futures market this week began signaling that physical oil supply is getting tight as well. The oil futures curve has become heavily “backwarded,” a condition that reflects very tight near-term supply. In fact, the last time we saw this tightness in near-term supply reflected in the futures curve was during the lead-up to Russia’s invasion of Ukraine, before oil spiked to almost $140 per barrel.
Despite market tightness and rising oil prices, however, shale, the global swing producer, can’t yet bail out this market. A Wall Street Journal article titled, “Oil Prices Near $100. Shale Isn’t Coming to the Rescue,” made clear this week that OPEC+ is completely in control of oil prices for now. In the article, Kirk Edwards, an executive at a Texas oil producer, said OPEC+ price setting power makes U.S. producers “gun shy.” “In one month, they can make a decision to put two million more barrels a day on the market, which will drive the price from $90 to $60.” In other words, the power OPEC+ has established over current oil prices is so absolute that, at this point, as both the CEOs of two large U.S. oil companies said this week, U.S. production will likely remain flat despite rising oil prices. In short, unless we see significantly “higher for longer” in the oil price as well, U.S. production isn’t in a position to address global supply shortages as long as OPEC+ holds the reins of prices so tightly. Again, this is a bad situation for oil prices, and by extension for inflation and a Fed trapped in a higher-for-longer policy stance slowly strangling the economy.
History proves that equity prices typically do crazy things at late cycle economic turning points in the months ahead of recession. After a sharp drop in the S&P since late July, the market is oversold again. Don’t be surprised if markets pop sharply. If they do, however, be on guard for the subsequent drop. Recession risks loom large, and the critical factors threatening “goldilocks” are beginning to take the upper hand. As BofA chief investment strategist Michael Hartnett reminds, “Bear markets don’t end without a recession or an event that causes the Fed to reverse policy.” Well, at present, oil is preventing the Fed from any reversal of policy, and higher-for-longer policy has a firm hand on the wheel—its course: recession.
As misbehaving energy markets dismantle the recent “goldilocks” environment, the name of the famed fairy tale can finally be retired and officially returned to its rightful confines in the annals of fantasyland. After all, as Arif Husain of T. Rowe Price says, when it comes to present economics, goldilocks is “an almost impossible fairytale in every sense of the word.” While bubble markets are still priced for soft-landing perfection, they will soon contend with an energy reality exposing a “goldilocks” fantasy.
Weekly performance: The S&P 500 was down 0.74%. Gold was hit by 4.09%. Silver was slammed, down 5.66%. Platinum was off 1.95%, and palladium was nearly flat, down 0.01%. The HUI gold miners index was crushed by 7.31%. The IFRA iShares US Infrastructure ETF dropped 2.56%. Energy commodities were volatile and higher on the week. WTI crude oil was up 0.84%, while natural gas gained 1.74%. The CRB Commodity Index lost 0.51%, and copper was up 1.11%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 1.18%. The Vanguard Utilities ETF VPU was down 6.68%. The dollar index was higher by 0.53% to close the week at 105.82. The yield on the 10-yr U.S. Treasury was up 15 bps to end the week at 4.59%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
