It was not terribly long ago, therefore it is almost a conditional reflex to cast minds back to the first half of 2022, where we find it pertinent and fitting to draw a parallel between the market reaction of Russia’s incursion of Ukraine and the recent flare up of tension in the Middle East. Both regions are important oil producers therefore events surrounding them will grab attention. The rally to $139/bbl last March was followed by a gradual erosion of value when it became obvious that oil supply was re-aligned but not disrupted. The current situation around the Red Sea is homogeneous. Longer voyage times will increase the cost of transport and insurance and refiners might be forced to draw on crude oil stocks but in the absence of actual and meaningful disruption shortage is implausible. And this will only happen in the unlikely event of Iran and/or Saudi Arabia being drawn into the conflict explicitly. Attempts to a temporary truce and US intentions to set up a maritime taskforce could also alleviate tension.

Which means that the current ascent will not last, similar to last year, correct? Well, the salient difference between the Russian occupation and the current hostilities is that back then inflation was rapidly rising, whilst currently it is falling (albeit a protracted supply bottlenecks might just push consumer prices somewhat higher again). So, it is not a far-fetched thought to attribute the present advance in prices as much to rate cut expectations, falling bond yields and dollar and healthy equity markets as to geopolitical temperature. In which case the dilemma is how resilient this support could be.

Mind the Gap!

The underlying causes of inflation are a considerable increase in aggregate demand, a significant decline in aggregate supply or the combination of the two. Recent elevated consumer prices were plausibly the function of both. The impact of the economic devastation caused by the Covid-19 pandemic was successfully mitigated by fiscal and monetary tools, the increase in government spending and near zero rates. Additionally, lockdowns all over the world resulted in accumulated savings and when health restrictions were lifted a wave of buying was unleashed driving consumer prices north.

On the supply side, the health crisis led to supply chain bottlenecks, particularly from China. Russia’s invasion of Ukraine and the consequent sanctions from the West and the weaponization of key raw materials from the East considerably added to inflationary pressures. The Consumer Price Index in the US grew 9.1% in June last year whilst in the euro zone the increase was above 10% year-on-year last October.

There are two great evils monetary policy makers dread: inflation and unemployment and sometimes it is a precarious task to decide which of these two to focus on. This time around the mission has been relatively straightforward. Bringing inflation down to the acceptable 2% level has been the priority and it could only be achieved by raising the cost of borrowing -in other words, employ contractionary monetary policy- which, in turn, would hinder economic growth and cool labour markets.

The tightening has worked, at least for now. Inflation, both headline and core, has been trending lower in the major economic centres of the world. Staying with the US and the euro zone CPI fell to 3.1% in November in the former (core stood at 4%) and to 2.4% in the common currency area with core reading at 3.6%. Reining in inflationary pressure has led to central banks halting the hikes in lending rates – both the Fed and the ECB decided to leave benchmark rates unchanged last week. The paths, however, might diverge in the early part of 2024.

The median projection amongst Fed officials as where interest rates would be by the end of 2024 retreated to 4.6% last week, down from 5.1% in September. No wonder then, that this dovish turn forced market participants to reassess their expectations and price in a combined 0.75% cut in 2024. On the other hand, the ECB president was at pains to stipulate that conditions for easing are not auspicious yet and emphasized that there has been ‘no discussion, no debate’ on lowering the cost of borrowing.

The predicted narrowing of the interest rate gap between the US and the euro zone (and other economic juggernauts) has naturally weakened the dollar, which has played a significant role in supporting oil prices in the past week or so. And of course, one must not ignore the axiomatic economic trivia that pausing and potentially cutting nominal interest rate will help stabilize or bring down the more significant real interest rate, which is the difference between the nominal rate and inflation (in our case the 2% target).

As laid out in yesterday’s note, a prolonged weakness in the dollar and the potential decline in real interest rates should provide a timely boost for the economy, which in turn will help oil demand recover. The stage, therefore, is set for stable to higher prices for next year and it is now time to dust off those $100+ price forecasts. If only life were as simple as that. There are at least two well-founded reasons to argue why any justified upside potential will remain limited. These are China and the US.

China has been the undisputable heartbeat of oil demand growth but its unquenchable thirst for oil is seemingly waning. The world’s second biggest economy was responsible for nearly 50% of this year’s oil demand growth (OPEC data). This will halve in 2024. China’s economy is stuttering. It will expand by less than 5% in 2023. Moody’s have put the country on a downgrade warning as it expects its economy to expand by a mere 4% next year. Perhaps, economic headwinds are not something to be surprised by when the country’s leadership made it abundantly clear in last week’s annual economic work conference that national security takes priority over growth. When ideology trumps pragmatism, the economy will inevitably suffer.

The US economy has gotten a massive boost from excess saving that was amassed during the pandemic. This ‘YOLO’ spending spree might already have come to an end or will do so in the foreseeable future. The ‘marginal propensity to consume’ (MPC), which shows the proportion of an extra dollar income spent versus saved will narrow and its support will be spectacularly withdrawn. The 5.2% growth rate registered in 3Q 2023, which was chiefly the function of the spending spree of this excess will not be repeated any time soon. The anticipated weakening of the dollar, together with the possible fall in real interest rates will be viewed as supportive, their impact, however, will be greatly cushioned by adverse developments in the two biggest economic powerhouses effectively capping growth in oil demand and hence in prices.

tamas.varga@pvm.co.uk