Oil
Expect the Middle East to create new and unexpected energy supply disruptions on top of the Russian energy shock.
Despite uncertainty and intrusive government policy, natural gas and oil markets have managed to direct much-needed supplies to Europe going into winter. Natgas markets attracted massive LNG inflows – at a cost of record-high prices – that now leave the continent’s on-land storage close to full. A floating LNG market now exists on Europe’s Atlantic Coast – made possible by spot prices at the Dutch Title Transfer Facility trading ~ 40% below 1Q23 futures. The TTF futures contango market structure allows unsold cargoes to be stored on vessels off the coast of Europe until needed this winter via hedging (e.g., buy spot, sell 2- to 3-month-forward futures to lock in storage costs). This expands storage for the continent, leaving the EU in much better shape to weather the loss of Russian pipeline gas.
Monetary and energy policy errors will keep oil- and gas-price volatility elevated. This will continue to weaken capex in conventional and renewable energy. Headline inflation will remain elevated. We remain long the XOP ETF, to retain exposure to the equities of oil and gas producers, which will benefit from these policy errors.
The G7’s attempt to insert itself in the oil-price-formation process performed by global trading markets will distort markets and the signals driving production, consumption and investment. The G7 will need a face-saving off-ramp to ditch this planner-based proposal. We expect Brent prices to move toward our expectations of $105/bbl in 4Q22 and $118/bbl in 2023, and remain long the XOP ETF.
OPEC 2.0’s decision to cut 2mm b/d of output beginning in December telescopes the loss of Russian volumes we expect over the course of the coming year. OPEC 2.0 clearly is not playing by the G7’s or the US’s rules. This will keep prices volatile.
Investors should go long US treasuries and stay overweight defensive versus cyclical sectors, large caps versus small caps, and aerospace/defense stocks. Regionally we favor the US, India, Southeast Asia, and Latin America, while disfavoring China, Taiwan, Hong Kong, eastern Europe, and the Middle East.
This week’s <i>Global Investment Strategy</i> report titled Fourth Quarter 2022 Strategy Outlook: A Three-Act Play discusses the outlook for the global economy and financial markets for the rest of 2022 and beyond.
Executive Summary Higher Brent Prices, Stronger Upside Bias The Fed is pacing a globally synchronized monetary-policy tightening cycle as the war in Ukraine escalates, following Russia’s mobilization of 300k reserve forces. Despite central-bank tightening, the intensification of the war increases the odds of higher inflation. This will keep the USD well bid. Russia’s threat to cut oil supplies to states observing the G7 price cap will test US and EU resolve as winter sets in. Retaliatory output cuts by Russia could send Brent crude oil prices above $200/bbl. The Biden administration remains fearful its G7 price cap and EU sanctions on Russian oil exports will spike prices. The US will make 10mm barrels of crude from its SPR available in November as a palliative. Our base case Brent forecast is slightly lower, averaging $105/bbl this year from $110/bbl, due to weaker realized prices. On the back of this, we expect 4Q22 Brent to average $106/bbl, and for 2023 to average $118/bbl, up slightly vs. last month. WTI will trade $3-$5/bbl lower. Bottom Line: The economic war pitting the EU and its allies against Russia could escalate and widen as more Russian troops pour into Ukraine. This raises the odds of expanded conflict outside Ukraine, and higher war-driven inflation. Our baseline forecast for 2023 remains intact, with a strong bias to the upside. We remain long the COMT and XOP ETFs to retain exposure to commodities. Feature The Fed is pacing a globally synchronized monetary-policy tightening cycle at a time when the war in Ukraine is escalating. Russia’s mobilization of a reported 300k reserve forces raises the spectre of an expansion of the Ukraine war – perhaps crossing into a NATO state’s border – if tactical nuclear, biological, or chemical weapons are used. This is a low-probability outcome, but it would increase the odds of significantly higher inflation should it come to pass.1 The US central bank lifted its Fed funds rate 75 bps Wednesday to a range of 3% - 3.25% – and strongly indicated further rate hikes will follow. The Fed is one of numerous banks increasing policy rates. This synchronous monetary-policy tightening has not been observed for 50 years, and raises the odds of a global economic recession, according to the World Bank.2 The World Bank notes that since 1970, recessions have been “preceded by a significant weakening of global growth in the previous year, as has happened recently,” and, importantly, “all previous global recessions coincided with sharp slowdowns or outright recessions in several major economies.” The withdrawal of monetary and fiscal support “are necessary to contain inflationary pressures, but their mutually compounding effects could produce larger impacts than intended, both in tightening financial conditions and in steepening the growth slowdown.” Markets are acting in a manner consistent with this assessment, but, in our view, need to expand the risk set to include a higher likelihood of a war widening beyond Ukraine. While this is not our base case, it is worthwhile recalling the link between war and inflation. Prior to and during the 20th century’s two world wars, then the Korean and Vietnam wars, US CPI inflation rose sharply (Chart 1).3 Price controls and tighter monetary policy were needed to address these inflationary episodes. Chart 1A Wider Ukraine War Would Stoke Inflation Stronger USD Remains Oil-Demand Headwind Fed policy will continue to push US interest rates higher, which will push the USD higher on the back of continued global demand for dollar-denominated assets. This will keep the cost of most commodities ex-US higher in local currency terms, which, all else equal, will weaken commodity demand in general, and oil demand in particular. This will be compounded if tighter monetary policy at systemically important central banks (led by the Fed) results in a global recession in 2023. This is especially true for EM oil demand: The income elasticity of EM oil consumption is 0.61, which means a 1% decrease (increase) in real EM GDP translates into a 0.61% decrease (increase) in oil demand, all else equal. In our base case, we expect global oil demand to grow 2.2mm b/d this year and 1.91mm b/d next year, roughly in line with the US EIA’s and IEA’s estimates (Chart 2). We expect EM demand will increase 1.25mm b/d this year, and 1.90mm b/d next year, accounting for almost all of global growth. As before, we expect China’s oil demand growth to be de minimus this year, on the back of its zero-tolerance COVID-19 policy. EM remains the key driver of our global oil demand assumptions, which, in our modeling, are a function of real income (GDP). Offsetting the stronger USD effects on demand is gas-to-oil switching demand, resulting from record-high LNG prices this year. This will add 800k b/d to demand globally this winter (November – March). Chart 2Global Oil Demand Holding Up Oil Supply Getting Tighter Oil supply will remain challenged this year and next, as core OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – approaches the limit of what it can supply to the market and still retain sufficient spare capacity to meet unexpected supply shocks (Chart 3). Among the anticipated shocks we believe core OPEC 2.0 is aware of is the loss of 2mm b/d of Russian crude oil output over the next year, due to the imposition of EU embargoes on seaborne crude oil and refined products, which will go into effect 5 December 2022 and 5 February 2023, respectively. The continued inability of non-core OPEC 2.0 states to maintain higher production – “The Other Guys” in our nomenclature – is another foreseeable shock (Chart 4). This is becoming acute for OPEC 2.0, given The Other Guys account for most of the 3.6mm b/d of below-quota output currently registered by the producer coalition.4 This is a record gap between expected production and actual production from OPEC 2.0, which was registered in August. Chart 3Core OPEC 2.0 Conserves Supplies Chart 4'Other Guys' Production Keeps Falling Net, demand will continue to outpace supply in our base case (Chart 5, Table 1). This will require continued inventory draws for the next year or so, as core OPEC 2.0 continues to conserve supplies (Chart 6). Chart 5Demand Continues To Outpace Supply Chart 6Inventory Will Continue Drawing Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Russian Wild Card Battlefield losses in Ukraine are forcing Russia’s military to activate some 300k reserve troops. These losses again are prompting veiled threats to deploy nuclear and perhaps chemical weapons, which drew a sharp warning from US President Biden.5 Further economic losses will begin mounting in a little more than two months, as the first of two major EU oil-import embargoes and a ban on insuring/re-insuring vessels carrying Russian crude and products takes hold. In addition, a US-led G7 price cap on Russian oil purchases will go into effect with the December embargo on seaborne crude imports into the EU.6 We continue to expect Russia will be forced to shut in ~ 2mm b/d of crude oil production by the end of next year – taking output from a little more than 10mm b/d to ~ 8mm b/d.7 Russian’s President Putin already has threatened to cut off oil supplies to anyone abiding by the G7 price cap.8 In our modeling, a unilateral 2mm b/d cut in Russian output – in addition to the lost sales from the EU embargoes and insurance/reinsurance bans – would take Brent prices above $200/bbl (Chart 7). On the downside, a severe global recession that removes 2mm b/d of demand next year could send prices below $60/bbl. Equally plausible cases for either outcome can be made, given current supply-demand fundamentals and the geopolitical backdrop discussed above. This can be seen in the lack of skew in the options markets, which is measured by the difference in out-of-the-money call and put implied volatilities (Chart 8). The skew sits close to zero at present – meaning options buyers are not giving higher odds to a sharp upside or downside move at present.9 Chart 7Higher Brent Prices, Stronger Upside Bias Chart 8Option Skew Shows Up Or Down Moves Equally Likely In our modeling and analysis, we continue to believe the balance of risk is to the upside. As can be seen in Chart 6, inventories are below the 2010-14 five-year average – OPEC 2.0’s original target when it was formed – which means KSA and the UAE will be able to respond to any demand shocks that cause unintended inventory accumulation (e.g., the sort that occurred during the COVID-19 pandemic or the OPEC market-share war of 2015-16). Managing the upside risk is more difficult: KSA and the UAE are close to the limits of what they can supply and still carry sufficient spare capacity to meet unexpected production losses. KSA’s crude oil output is just over 11mm b/d, and the UAE’s is at 3.2mm b/d, according to OPEC’s Monthly Oil Market Report. This puts both within 1mm b/d of their max production capacity of 12mm and 4mm b/d. Both got close to producing at these max levels in early 2020, when Russia provoked a market share war; this was quickly reversed as a magnitude of the COVID-19 demand destruction became apparent. The only other large producer outside the OPEC 2.0 coalition capable of increasing and sustaining higher output is the US shales, which are producing at 7.8mm b/d and have pushed total US crude oil output to 12.2mm b/d (Chart 9). Leading producers in the shales have foreclosed any sharp increase in output this year, given tight labor markets and services and equipment markets in the US. Chart 9US Shales Close To Max Output Investment Implications Global crude oil markets remain tight, with demand continuing to exceed supply. The risk that the economic war pitting the EU and its allies against Russia could expand to a more kinetic confrontation involving additional states is higher, as more Russian troops are called up to serve in Ukraine. If the additional troops do not reverse Russia’s battlefield losses – or if Ukraine looks like it will win this war – Putin likely will feel cornered, and get more desperate.10 We believe Putin will first attempt to impose as much economic pain on the West as possible by cutting off all natural gas and oil flows to the EU and states and firms observing the G7 price cap. However, if that does not force the West to relent on its economic war with Russia, a war with NATO could evolve in which tactical nukes or other weapons of mass destruction are employed. At that point, Putin would have concluded there would be nothing he could do to restore Russia’s standing as a world power. Any plume – nuclear, biological or chemical (NBC) – that crosses a NATO border likely would be treated as an act of war. NATO would have to act at that point. This is not our expectation, nor is it any part of our base case. But it is a higher non-trivial risk than it was last month or last week. This raises the odds of higher war-driven inflation, as well, which will further complicate central-bank monetary policy at a time of war. Our baseline forecast remains intact, with a strong bias to the upside. We remain long the COMT and XOP ETFs to retain exposure to commodities. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish In its September update, the US EIA reported natural gas consumption will hit record levels in 2022, increasing by 3.6 Bcf/d to just under 87 Bcf/d on average, led by increases in the electric power residential and commercial sectors (Chart 10). US natural gas consumption in the electric power sector will increase in 2022 due to limitations at coal-fired power plants and weather-driven demand. It is expected to decrease in 4Q22 and in 2023, due to more renewable electricity generation capacity. Natural gas consumption in the residential and commercial sectors for 2023 is expected to be similar as 2022 levels. Base Metals: Bullish According to Eurometaux, a consortium of European metal producers, approximately 50% of the EU’s zinc and aluminum production capacity is offline due to high power prices. More operations are expected to shut as European power prices remain elevated and metal prices drop on recessionary fears (Chart 11). The decision to reopen a smelter following a shutdown is expensive and can result in long wait times. This will make the bloc’s manufacturers heavily reliant on metal imports from other states, which likely will lead to higher pollution from these plants. Aluminum supply is particularly vulnerable to this power crisis since one ton needs an eye-watering 15 megawatt-hours of electricity – enough to power five homes in Germany for a year. Precious Metals: Neutral The Fed’s additional 75-bps rate hike will strengthen the USD and weaken gold prices. Geopolitical risk has been a tailwind for the greenback thus far, as investors rush to the USD instead of the yellow metal for safe-haven investments. If this trend continues, along with further Fed rate increases, the additional risk arising from Putin’s reserve force mobilization and possible expansion of the Ukraine war will boost the USD and leave gold in the doldrums. Chart 10 Chart 11 Footnotes 1 Please see Vladimir Putin mobilises army reserves to support Ukraine invasion, published by ft.com on September 21, 2022. 2 Please see Is a Global Recession Imminent?, published by the World Bank on September 15, 2022. The report notes, “Policymakers need to stand ready to manage the potential spillovers from globally synchronous withdrawal of policies supporting growth. On the supply-side, they need to put in place measures to ease the constraints that confront labor markets, energy markets, and trade networks.” 3 Please see One hundred years of price change: the Consumer Price Index and the American inflation experience, published by the US Bureau of Labor Statistics in April 2014. 4 Please see OPEC+ supply shortfall now stands at 3.5% of global oil demand, published 20 September 2022 by reuters.com. 5 Please see Biden warns Putin over nuclear, chemical weapons, published by politico.eu on September 17, 2022. 6 Please see EU Russian Oil Embargoes, Higher Prices, which we published on August 18, 2022, for discussion. 7 We include Russia among “The Other Guys” in our balances estimates. 8 Please see Explainer: The G7's price cap on Russian oil begins to take shape, published by reuters.com on September 19, 2022. 9 We use the standard measure of skew – i.e., the difference between 25-delta calls and puts – to determine whether option market participants are discounting a higher likelihood of an up or down move, respectively. 10 Please see CIA director warns Putin's 'desperation' over Russia's failures in Ukraine could lead him to use nukes, published by businessinsider.com on April 15, 2022. Investment Views and Themes Strategic Recommendations Trades Closed in 2022
Executive Summary The US inflation surprise increases the odds of both congressional gridlock and recession, which increases uncertainty over US leadership past 2024 and reduces the US’s ability to lower tensions with China and Iran. Despite the mainstream media narrative, the Xi-Putin summit reinforces our view that China cannot reject Russia’s strategic partnership. The potential for conflict in Taiwan forces China to accept Russia’s overture. For the same reason the US and China cannot re-engage their economies sustainably, even if Biden and Xi somehow manage to reduce tensions after the midterm elections and twentieth national party congress. Russia could reduce oil exports as well as natural gas, intensifying the global energy shock. Ukraine’s counter-offensive and Europe’s energy diversification increase the risk of Russian military and economic failure. The Middle East will destabilize anew and create a new source of global energy supply disruptions. US-Iran talks are faltering as expected. Russian Oil Embargo Could Deliver Global Shock Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 19.1% Bottom Line: Stay long US stocks, defensive sectors, and large caps. Avoid China, Taiwan, eastern Europe, and the Middle East. Feature Several notable geopolitical developments occurred over the past week while we met with clients at the annual BCA Research Investment Conference in New York. In this report we analyze these developments using our geopolitical method, which emphasizes constraints over preferences, capabilities over intentions, reality over narrative. We also draw freely from the many valuable insights gleaned from our guest speakers at the conference. China Cannot Reject Russia: The Xi-Putin Summit In Uzbekistan Presidents Xi Jinping and Vladimir Putin are meeting in Uzbekistan as we go to press and Putin has acknowledged China’s “questions and concern” about the war in Ukraine.1 They last met on February 4 when Xi gave Putin his blessing for the Ukraine invasion, promising to buy more Russian natural gas and to pursue a “no limits” strategic partnership (meaning one that includes extensive military cooperation). The meeting’s importance is clear from both leaders’ efforts to make it happen. Putin is leaving Russia despite rising domestic criticism over his handling of the Ukraine war and European energy war. Ukraine is making surprising gains in the battlefield, particularly around Kharkiv, threatening Russia’s ability to complete the conquest of Donetsk and the Donbas region. Meanwhile Xi is leaving China for the first time since the Covid-19 outbreak, despite the fact that he is only one month away from the most important political event of his life: the October 16 twentieth national party congress, where he hopes to clinch another five, ten, or fifteen years in power, expand his faction’s grip over the political system, and take over Mao Zedong’s unique title as chairman of the Communist Party. We do not yet know the full outcome of the Uzbek summit but we do not see it as a turning point in which China turns on Russia. Instead the summit reinforces our key point to investors all year: China cannot reject Russia. Russia broke energy ties with Europe and is fighting a proxy war with NATO. The Putin regime has lashed Russia to China’s side for the foreseeable future. China may not have wanted to move so quickly toward an exclusive relationship but it is not in a position to reject Russia’s diplomatic overture and leave Putin out to dry. The reason is that China is constrained by the US-led world order and like Russia is attempting to change that order and carve a sphere of influence to improve its national security. Beijing’s immediate goal is to consolidate power across the critical buffer territories susceptible to foreign interests. It has already consolidated Tibet, Xinjiang, Hong Kong, and to some extent the South China Sea, the critical approach to Taiwan. Taiwan is the outstanding buffer space that needs to be subjugated. Xi Jinping has taken it upon himself to unify China and Taiwan within his extended rule. But Taiwanese public opinion has decisively shifted in favor of either an indefinite status quo or independence. Hence China and Taiwan are on a collision course. Regardless of one’s view on the likelihood of war, it is a high enough chance that China, Taiwan, the US, and others will be preparing for it in the coming years. Chart 1US Arms Sales To Taiwan The US is attempting to increase its ability to deter China from attacking Taiwan. It believes it failed to deter Russia from invading Ukraine – and Taiwan is far more important to US economy and security than Ukraine. The US is already entering discussions with Taiwan and other allies about a package of severe economic sanctions in the event that China attacks – sanctions comparable to those imposed on Russia. The US Congress is also moving forward with the Taiwan Policy Act of 2022, which will solidify US support for the island as well as increase arms sales (Chart 1).2 Aside from China's military preparation – which needs to be carefully reviewed in light of Russia’s troubles in Ukraine and the much greater difficulty of invading Taiwan – China must prepare to deal with the following three factors in the event of war: 1. Energy: China is overly exposed to sea lines of communication that can be disrupted by the United States Navy. Beijing will have to partner with Russia to import Russian and Central Asian resources and attempt to forge an overland path to the Middle East (Chart 2). Unlike Russia, China cannot supply its own energy during a war and its warfighting capacity will suffer if shortages occur or prices spike. 2. Computer Chips: China has committed at least $200 billion on a crash course to build its own semiconductors since 2013 due to the need to modernize its military and economy and compete with the US on the global stage. But China is still dependent on imports, especially for the most advanced chips, and its dependency is rising not falling despite domestic investments (Chart 3). The US is imposing export controls on advanced microchips and starting to enforce these controls on third parties. The US and its allies have cut off Russia’s access to computer chips, leading to Russian shortages that are impeding their war effort. Chart 2China’s Commodity Import Vulnerability Chart 3China's Imports Of Semiconductors 3. US Dollar Reserves: China is still heavily exposed to US dollar assets but its access will be cut off in the event of war, just as the US has frozen Russian, Iranian, Venezuelan, and Cuban assets over the years. China is already diversifying away from the dollar but will have to move more quickly given that Russia had dramatically reduced its exposure and still suffered severely when its access to dollar reserves was frozen this year (Chart 4). Where will China reallocate its reserves? To developing and importing natural resources from Russia, Central Asia, and other overland routes. Chart 4China's US Dollar Exposure Russia may be the junior partner in a new Russo-Chinese alliance but it will not be a vassal. Russia has resources, military power, and regional control in Central Asia that China needs. Of course, China will maintain a certain diplomatic distance from Russia because it needs to maintain economic relations with Europe and other democracies as it breaks up with the United States. Europe is far more important to Chinese exports than Russia. China will play both sides and its companies will develop parallel supply chains. China will also make gestures to countries that feel threatened by Russia, including the Central Asian members of the Shanghai Cooperation Organization (SCO). But the crucial point is that China cannot reject Russia. If the Putin regime fails, China will be diplomatically isolated, it will lose an ally in any Taiwan war, and the US will have a much greater advantage in attempting to contain China in the coming years and decades. Russo-Chinese Alliance And The US Dollar Many investors speculate that China’s diversification away from the US dollar will mark a severe downturn for the currency. This is of course possible, given that Russia and China will form a substantial anti-dollar bloc. Certainly there can be a cyclical downturn in the greenback, especially after the looming recession troughs. But it is harder to see a structural collapse of the dollar as the leading global reserve currency. The past 14 years have shown how global investors react to US dysfunction, Russian aggression, and Chinese slowdown: they buy the dollar! The implication is that a US wage-price spiral, a Russian détente with Europe, and a Chinese economic recovery would be negative for the dollar – but those stars have not yet aligned. Related Report Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War The reason China needs to diversify is because it fears US sanctions when it invades Taiwan. Hence reducing its holdings of US treasuries and the dollar signals that it expects war in future. But will other countries rush into the yuan and yuan-denominated bonds if Xi is following in Putin’s footsteps and launching a war of choice, with damaging consequences for the economy? A war over Taiwan would be a global catastrophe and would send other countries plunging into the safe-haven assets, including US assets. Nevertheless China will diversify and other countries will probably increase their yuan trade over time, just as Russia has done. This will be a cyclical headwind for the dollar at some point. But it will not knock the US off the premier position. That would require a historic downgrade in the US’s economic and strategic capability, as was the case with the United Kingdom after the world wars. China will continue to stimulate the economy after the party congress. A successful Chinese and global economic rebound next year – and a decision to pursue “jaw jaw” with the US and Taiwan rather than “war war” – would be negative for the dollar. Hence we may downgrade our bullish dollar view to neutral on a cyclical basis before long … but not yet and not on a structural basis. Bottom Line: Favor the US dollar and the euro over the Chinese renminbi and Taiwanese dollar. Underweight Chinese and Taiwanese assets on a structural basis. Ukraine’s Counter-Offensive And A Russian Oil Embargo Ukraine launched a counter-offensive against Russia in September and achieved significant early victories. Russians fell back away from Kharkiv, putting Izyum in Ukrainian hands and jeopardizing Russia’s ability to achieve its war aim of conquering the remaining half of Donetsk province and thus controlling the Donbas region of eastern Ukraine. Russian positions also crumbled west of the Dnieper river, which was always an important limit on Russian capabilities (Map 1). Map 1Status Of Russia-Ukraine War: The Ukrainian Counter-Offensive (September 15, 2022) Some commentators, such as Francis Fukuyama in the Washington Post, have taken the Ukrainian counter-offensive as a sign that the Ukrainians will reconquer lost territory and Russia will suffer an outright defeat in this war.3 If Russia cannot conquer the Donbas, its control of the “land bridge” to Crimea will be unsustainable, and it may have to admit defeat. But we are very skeptical. It will be extremely difficult for Ukrainians to drive the Russians out of all of their entrenched positions. US military officials applauded Ukraine’s counter-offensive but sounded a cautious note. The chief problem is that neither President Putin nor the Russian military can afford such a defeat. They will have to double down on the Donbas and land bridge. The war will be prolonged. Ultimately we expect stalemate, which will be a prelude to ceasefire negotiations. But first the fighting will intensify and the repercussions for global economy and markets will get worse. Russia’s war effort is also flagging because Europe is making headway in finding alternatives for Russian natural gas. Russia has cut off flows through the Nord Stream pipeline to Germany, the Yamal pipeline to Poland, and partially to the Ukraine pipeline system, leaving only Turkstream operating normally. Yet EU gas storage is in the middle of its normal range and trending higher (Chart 5). Chart 5Europe Handling Natural Gas Crisis Well … So Far Of course, Europe’s energy supply is still not secure. Cold weather could require more heating than expected. Russia has an incentive to tighten the gas flow further. Flows from Algeria or Azerbaijan could be sabotaged or disrupted (Chart 6). Chart 6Europe’s NatGas Supply Still Not Secure Chart 7Europe Tipping Into Recession Anyway Russia’s intention is to inflict a recession on Europe so that it begins to rethink its willingness to maintain a long-term proxy war. Recession will force European households to pay the full cost of the energy breakup with Russia all at once. Popular support for war will moderate and politicians will adopt more pragmatic diplomacy. After all they do not have an interest in prolonging the war to the point that it spirals out of control. Clearly the economic pain is being felt, as manufacturing expectations and consumer confidence weaken (Chart 7). Europe’s resolve will not collapse overnight. But the energy crisis can get worse from here. The deeper the recession, the more likely European capitals will try to convince Ukraine to negotiate a ceasefire. However, given Ukraine’s successes in the field and Europe’s successes in diversification, it is entirely possible that Russia faces further humiliating setbacks. While this outcome may be good for liberal democracies, it is not good for global financial markets, at least not in the short run. If Russia is backed into a corner on both the military and economic fronts, then Putin’s personal security and regime security will be threatened. Russia could attempt to turn the tables or lash out even more aggressively. Already Moscow has declared a new “red line” if the US provides longer-range missiles to Ukraine. A US-Russia showdown, complete with nuclear threats, is not out of the realm of possibility. Russia could also start halting oil exports, as it has threatened to do, to inflict a major oil shock on the European economy. Investors will need to be prepared for that outcome. Bottom Line: Petro-states have geopolitical leverage as long as global commodity supplies remain tight. Investors should be prepared for the European embargo of Russian oil to provoke a Russian reaction. A larger than expected oil shock is possible given the risk of defeat that Russia faces (Chart 8). Chart 8Russian Oil Embargo Could Deliver Global Shock US-Iran Talks Falter Again This trend of petro-state geopolitical leverage was one of our three key views for 2022 and it also extends to the US-Iran nuclear negotiations, which are faltering as expected. Tit-for-tat military action between Iran and its enemies in the Persian Gulf will pick up immediately – i.e. a new source of oil disruption will emerge. If global demand is collapsing then this trend may only create additional volatility for oil markets at first, but it further constrains the supply side for the foreseeable future. It is not yet certain that the talks are dead but a deal before the US midterm looks unlikely. Biden could continue working on a deal in 2023-24. The Democratic Party is likely to lose at least the House of Representatives, leaving him unable to pass legislation and more likely to pursue foreign policy objectives. The Biden administration wants the Iran deal to tamp down inflation and avoid a third foreign policy crisis at a time when it is already juggling Russia and China. The overriding constraints in this situation are that Iran needs a nuclear weapon for regime survival, while Israel will attack Iran as a last resort before it obtains a nuclear weapon. Yes, the US is reluctant to initiate another war in the Middle East. But public war-weariness is probably overrated today (unlike in 2008 or even 2016) and the US has drawn a hard red line against nuclear weaponization. Iran will retaliate to any US-Israeli aggression ferociously. But conflict and oil disruptions will emerge even before the US or Israel decide to launch air strikes, as Iran will face sabotage and cyber-attacks and will need to deter the US and Israel by signaling that it can trigger a region-wide war. Chart 9If US-Iran Talks Fail, Iraq Will Destabilize Further Recent social unrest in Iraq, where the nationalist coalition of Muqtada al-Sadr is pushing back against Iranian influence, is only an inkling of what can occur if the US-Iran talks are truly dead, Iran pushes forward with its nuclear program, and Israel and the US begin openly entertaining military options. The potential oil disruption from Iraq presents a much larger supply constraint than the failure to remove sanctions on Iran (Chart 9). A new wave of Middle Eastern instability would push up oil prices and strengthen Russia’s hand, distracting the US and imposing further pain on Europe. It would not strengthen China’s hand, but the risk itself would reinforce China’s Eurasian strategy, as Beijing would need to prepare for oil cutoffs in the Persian Gulf. Iran’s attempts to join the Shanghai Cooperation Organization should be seen in this context. Ultimately the only factor that could still possibly convince Iran not to make a dash for the bomb – the military might of the US and its allies – is the same factor that forces China and Russia to strengthen their strategic bond. The emerging Russo-Chinese behemoth, in turn, acts as a hard constraint on any substantial reengagement of the US and Chinese economies. The US cannot afford to feed another decade of Chinese economic growth and modernization if China is allied with Russia and Central Asia. Of course, we cannot rule out the possibility that the Xi and Biden administrations will try to prevent a total collapse of US-China relations in 2023. If China is not yet ready to invade Taiwan then there is a brief space for diplomacy to try to work. But there is no room for long-lasting reengagement – because the US cannot simply cede Taiwan to China, and hence China cannot reject Russia, and Russia no longer has any options. Bottom Line: Expect further oil volatility and price shocks. Sell Middle Eastern equities. Favor North American, Latin American, and Australian energy producers. Investment Takeaways Recession Risks Rising: The inflation surprise in the US in August necessitates more aggressive Fed rate hikes in the near term, which increases the odds of rising unemployment and recession. US Policy Uncertainty Rising: A recession will greatly increase the odds of US political instability over the 2022-24 cycle and reduce the incentive for foreign powers like Iran or China to make concessions or agreements with the US. European Policy Uncertainty Rising: We already expected a European recession. Russia’s setbacks make it more likely that it will adopt more aggressive military tactics and economic warfare. Chinese Policy Uncertainty Rising: China will continue stimulating next year but its economy will suffer from energy shocks and its stimulus is less effective than in the past. It will likely increase economic and military pressure on Taiwan, while the US will increase punitive measures against China. It is not clear that it will launch a full scale invasion of Taiwan – that is not our base case – but it is possible so investors need to be prepared. Long US and Defensives: Stay long US stocks over global stocks, defensive sectors over cyclicals, and large caps over small caps. Buy safe-havens like the oversold Japanese yen. Long Arms Manufacturers: Buy defense stocks and cyber-security firms. Short China and Taiwan: Favor the USD and EUR over the CNY. Favor US semiconductor stocks over Taiwanese equities. Favor Korean over Taiwanese equities. Favor Indian tech over Chinese tech. Favor Singaporean over Hong Kong stocks. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Tessa Wong and Simon Fraser, “Putin-Xi talks: Russian leader reveals China's 'concern' over Ukraine,” BBC, September 15, 2022, bbc.com. 2 US Senate Foreign Relations Committee, “The Taiwan Policy Act of 2022,” foreign.senate.gov. 3 Greg Sargent, “Is Putin facing defeat? The ‘End of History’ author remains confident,” Washington Post, September 12, 2022, washingtonpost.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix
Listen to a short summary of this report Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Chart 7Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding. Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices. Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply. Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores