Markets start to focus on the risk of deflation

Financial markets are treading water as they wait to see what happens next. Will demand pick up and drive the economy forward? Or will over-supply lead to deflation?



Markets start to focus on the risk of deflation – Oil

We focus on Brent as the global benchmark.

The market closed Friday at $32.80/bbl, a rise of just $1/bbl on the week.

As we expected, traders ramped up the WTI futures contract for June as it came close to Monday’s close. Experienced investors know not to trade the near-month contracts, because of the potential for manipulation. And sure enough, the contract jumped 9% in a day on Thursday.

Wednesday’s report of a minor fall in US inventories provided the perfect excuse to bid up prices. But in reality, there is little to suggest supply/demand balances have suddenly changed. Tom Tom real-time traffic data for New York, for example, is still very negative – as are other major cities such as Houston and Atlanta which have ‘reopened’ after the lockdowns.

Common sense instead suggests that refinery inventories are reducing ahead of the Memorial Day weekend, which marks the start of the driving season:

  • The only storage data available is at refineries, but much more volume is stored by distributors, gasoline stations and motorists themselves
  • It seems likely that the value chain destocked heavily  in early March as prices collapsed from $50/bbl to the negative levels seen last month
  • In turn, dealers and garages may well now be taking advantage of today’s low prices to restock ahead of Memorial Day
  • Motorists may well have also decided to fill their tanks as prices were low

This switch in dealer and garage storage could easily have caused the small 747kb fall in refinery inventory that we saw – and might create a further draw this week.

But looking ahead, Bloomberg data shows >50mb of Saudi crude now approaching the US Gulf and West Coast. Oil prices have also reached a strong ‘resistance point’ as the chart shows. So traders may well start taking their profits as the tankers near port.


S&P 500

Markets start to focus on the risk of deflation – S&P 500

We focus on the US S&P 500 Index as the world’s major stock market index.

The market closed Friday at 2864, giving back most of its gain in the previous week. As the chart confirms, the S&P 500 has been trading in a 250 point range over the past month:

  • The speculators would like to push it higher, assuming a fast V-shaped recovery is underway
  • But the news on the economy, earnings and employment remains very negative, as the US Federal Reserve warned Friday:

“Asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course, the economic fallout prove more adverse, or financial system strains reemerge… All told, the prospect for losses at financial institutions to create pressures over the medium term appears elevated.

“The outlook for the pandemic and economic activity is uncertain. In the near term, risks associated with the course of COVID-19 and its effect on the U.S. and global economies remain high. In addition, there is potential for stresses to interact with preexisting vulnerabilities stemming from financial system or fiscal weaknesses in Europe, China, and emerging market economies. These risks have the potential to interact with the vulnerabilities identified in this report and pose additional risks to the U.S. financial system.”


Interest rates

Markets start to focus on the risk of deflation – Interest Rates

We focus on the US 10-year rate, as this is the “risk-free” benchmark for global markets.

The rate closed Friday at 0.64%, retracing most of its increase in the previous week. And the market now seems caught between two opposing forces:

  • It wants to believe the $7tn now pumped into the economy by the US Federal Reserve will lead to a quick recovery and inflation
  • But China’s Producer Price Index fell further in April to -3.1%, and the US Consumer Price Index fell to 0.3%, increasing the risks of deflation

None of us have any experience of deflation. And so the change from inflation, if it comes, will take time to absorb.

One key impact is that deflation means prices will be cheaper tomorrow, and so it pays to wait before buying if one can. Deflation also means that the cost of debt increases in real terms – rather than reducing with inflation.


US employment

The data on the economy continue to be shocking, as the chart showing the change in US employment levels confirms. Jobless claims between 20 March – 9 May totalled 24% of February 2020 employment.

As always, the poorest in society are being worst hit, as they have fewer reserves to fall back on. As the Federal Reserve reported:

“39% of former workers living in a household earning $40,000 or less lost work, compared with 13% in those making more than $100,000.”

Equally worrying is that “three in 10 adults said they could not cover three months’ worth of expenses with savings or borrowing in the case of a job loss, indicating that they were not prepared for the current financial challenges.”

These facts highlight the challenge ahead. Central banks can supply cash to the markets, but they cannot stop companies going bankrupt if consumers can’t afford to buy their products.

As the Fed recognises, this creates the potential for a very vicious circle to develop, where companies close and lay off workers; causing more companies to close and lenders to further tighten loan standards to avoid losses; and in turn causing yet more closures and job losses.

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