Anyone keeping his/her finger on the pulse of financial markets feels elevated heartbeat. Whether it is the sign of excitement that the recent symptoms were those of panic attacks and the patience is otherwise in good health or hides growing anxiety that an infectious disease called recession is about to spread faster than the Covid-19 virus in 2020 is ambivalent. The first diagnosis was grim indeed but a second opinion before the best of course of action is decided is advisable and even necessary.

There are several questions that need to be answered before definite verdict is established. Is the bloodbath seen in the equity markets an overreaction or was the preceding bull market overdone? Whatever the answer is it shows how the financialization of markets distorts the underlying fundamental picture. Take the recent performance of Japan’s main stock index.  A fall of 20% in the space of three trading sessions has been followed by a sharp rebound of almost 10% in just one day followed by another 3% rally. It is tempting to label these violent trading conditions abnormal and beyond comprehension but based on the experiences of the last decade or so these aberrations have become sporadic norms.

When going through research and analysis from a week ago you hardly find any prognosis that would have foreseen the chain of events that kicked off last Thursday. Yet, every analyst, including ourselves, was desperate to find hints and answers that shed light on the method to this madness. One of these explanations can be found in the Land of Rising Sun in the form of rising currency. The latest decision of the Bank of Japan to increase interest rates took many by surprise. The yen strengthened against the dollar and other currencies sending shockwaves throughout markets as Japanese exporters were expected to feel the brunt of the rallying yen. Consequently, carry trades, whereas investors borrow money in currencies with low interest rates to invest in assets with higher yields were reversed and the impact was painfully felt in the Japanese equity and forex markets.

Undeniably, the turmoil in the Far East was a piece of the jigsaw puzzle but probably not the largest one. The full force of the panic began to be felt when the US nonfarm payroll data was published on Friday afternoon and it disappointed – that is bad news is considered bad news. The number of US jobs grew 114,000 last month, way below expectations and unemployment ticked up to 4.3%. It led to an increased fear of recession and a deeper and possibly earlier rate cut by the Federal Reserve than originally anticipated. The plausible lowering of borrowing costs triggered a rush into bonds sending yields sharply lower and pushed equities and the dollar over the precipice but since the view on economic prospects darkened significantly the weak dollar was not able to support oil, the black gold was dragged down, too.

Fingers for the meltdown have been pointed at the Fed. At this point it is worth recalling the US central bank’s dual mandate: it is to promote stable prices and maximum employment. Well, inflation is well on its way to the target level of 2%. US headline inflation retreated to 3% in July from 9.1% in June 2022 and the lowest reading since February 2021. The core number plunged to 3.3%, halving the value seen in September 2022. Unemployment edging to 4.3% has also been deemed to be a well-founded worry, yet, what we find is that the natural rate of unemployment, or the non-cyclical unemployment rate, which is the minimum rate affected by economic forces is predicted to be 4.4% in 4Q 2024, sourcing data from the US Congressional Budget Office.

It appears that the Federal Reserve has done a brilliant job in fulfilling its mandate in the face of economic turmoil precipitated first by the health crisis originating from China and then by the added inflationary pressure resulting from the nefarious invasion of Ukraine. It is getting ever so closer reining inflation in without hard landing. The central bank has always said that their decision to manage interest rates would be data driven and one can only pray that overreaction to economic developments will not alter this course as it might re-ignite upside pressure on consumer prices.

Of course, one can never underestimate the power of sentiment and at this stage of would be a brazen attempt to conclude that the bottom has been reached. There are, however, a few implications that will play a salient role in shaping perspectives and prices going forward, which must be kept in mind. If the underlying grim view on recession persists, inflation will be further mitigated. Part of it will be moderating US retail gasoline prices, which will do a huge service to Democrats to win the November presidential election. Lowering the price of money, whenever it comes, is akin to lowering the price of oil. The former stimulates aggregate consumer demand and supports the economy, the latter incentivizes oil consumption. The fragile state of the Chinese economy will plausibly remain an impediment as far as economic and oil demand growth is concerned, as embodied in the latest aet of data. It showed Chinese crude oil imports falling to their lowest for nearly 2 years in July, although commodity imports rose 7.2% year-on-year. Yet, what we have seen in the last few days seem more of a sentiment-driven, maybe even panicky, move, as herd mentality helped prices de-couple from reality.

Demand Growth remains Resilient

After few days of turbulence, a sense of calm has been instilled amongst investors. Whether the reversal in risk asset prices will prove to be a mere bottom-picking before the sell-off continues or investors have taken the time to thoroughly assess the medium-term implications of the US job data is open for debate. What, however, has become clear is that the EIA did not see any reason to lower its oil demand growth estimates for this year and albeit absolute demand forecast for 2H 2024 was downgraded, it paled in comparison with the cut in non-DoC supply. In other words, the call on DoC oil has risen a tad for the balance of the year and the EIA still expects global stock drawdown. Further support was provided by the Iranian pledge to retaliate against Israel after the killing of a Hezbollah and a Hamas leader and Libyan protests, which shut part of the Sharara field was an additional catalyst for the rally. Prices initially rose further overnight notwithstanding builds across the board in US oil inventories reported by the API post-settlement.

Equities also experienced a relief rally and the dollar strengthened. No doubt, Fed luminaries did their best to re-assure markets that Friday’s job data does not equal recession, far from it. And herein lies the simplified answer to the latest turmoil: those who firmly believe that economic contraction is inevitable will be happy to desert equities and commodities in the foreseeable future but the rest, and they are probably the majority, will be reluctant to do so unless genuine signs of recession emerge.

Overnight Pricing

© 2024 PVM Oil Associates Ltd