5 October 2020
Low volatility is either a sign that things are going well, or of complacency. As we go into Q4, “fear indices” for bonds and stocks remain at low levels. But oil prices have begun to weaken, whilst Europe has slipped into deflation.
We focus on Brent as the global benchmark.
Prices closed at $39.26/bbl, finally falling out of the narrow trading range established since June and closing below the psychologically important $40/bbl line.
The issue is simply that demand remains weak. US refineries have been forced to cut operating rates (which are now 19% below normal), to control diesel and jet fuel stocks. But, of course, this simply shifts the problem of over-supply upstream to crude oil.
Meanwhile, producers are becoming desperate for revenue after nearly 6 months of output cuts. The US oil rig count rose again last week, whilst Libyan exports are already up by 260kbd and Saudi exports are up 480kbd – after having forced the UAE to cut by a similar amount to compensate for earlier over-production.
Producers are therefore facing the familiar trade-off between price and volume. As discussed last week, we see the potential for much lower prices as we go through Q4, in order to justify the high cost of floating storage. And at some point during the quarter, OPEC+ will face a tricky decision about whether to continue with its planned 2mbd quota increase in January.
We focus on the US S&P 500 Index as the world’s major stock market index.
The market closed up for the first week in a month at 3348 in spite of Friday’s 1% fall on news of President Trump’s Covid-19 diagnosis. The VIX “fear index” moved lower, and remains well below June’s level due to the market’s belief that more Federal Reserve stimulus is on the way.
In the real world, however, uncertainty remains at elevated levels, focused on:
- President Trump’s refusal to commit during the debate to accepting defeat in the election. His illness heightens concerns over the outlook for the next few weeks
- The ongoing impact of the Covid-19 pandemic on the economy, especially with Congress deadlocked over further fiscal stimulus – and with furlough payments ending
The Fed clearly believes it can control these risks by printing more money – it is, after all, already the world’s largest investor as we discussed last week. But does this really mean that markets can never fall? Generally speaking, after all, whenever something is “too good to be true” – it turns out that it is.
We focus on the US 10-year rate, as this is the “risk-free” benchmark for global markets.
The rate remined plateaued, ending up slightly at 0.69%.
Most players agree that the bond market is usually “smarter” than the equity market, and so the record low in the MOVE “fear index” for interest rates is striking – especially when combined with the near-record level of the S&P Index. As the chart shows, the last time this occurred was ahead of the 2008 crisis:
- Interest rates would normally be rising if an economic recovery was underway, as this would push up inflation
- But in reality, inflation is already turning to deflation in key markets outside the USA, as the chart below confirms
- Today’s interest rates are close to all-time lows, and so the lack of volatility would suggest bond markets expect this weakness to continue – despite the optimism in equity markets
The critical point is that both markets can’t be right. If equities are fairly priced, then interest rates must rise – or vice versa. And in the real world, as we discuss above, there are plenty of reasons to worry about the economic and political outlook.
Central banks have spent the last decade promising to create inflation. Their idea was that inflation would create new demand, as people would rush to buy before prices rose. But they have not been very successful, as the chart confirms:
- Over-capacity means that China, as the manufacturing capital of the world, is now exporting deflation. Its Producer Price Index has been negative since July last year
- Japan’s Consumer Price Index has been negative for much of this year, and now the Eurozone CPI has joined it in negative territory
- The UK is barely positive at just 0.2% in August, whilst the US is the outlier with CPI at 1.3% – due to the weak dollar and the impact of the oil price rise (most countries outside the USA have high gasoline taxes, so oil price movements are not so critical as a percentage of the price)
The central banks’ real problem is that the West is now an ageing society. Increasing life expectancy means that more that half of its population increase over the next decade will be in the Perennial’s 55+ generation. And the number of those in the Wealth Creator 25 – 54 age group will actually fall due to lower birth rates.
The reason these demographics matter is that Wealth Creators create demand as they settle down, have children and move up in their careers. But the Perennials are a replacement economy, as they already own most of what they need.
Essentially, therefore, the stimulus programmes have been trying to “print babies” to overcome this demographic deficit. Unfortunately, the end-result has simply been to create $tns of debt which can never be repaid.