Inflation, interest rates and energy - oil is almost the only game in town

Inflation, interest rates and energy - oil is almost the only game in town

20 April 2022 from Mikael Syding

CMEgroup.com always has updated probabilities for the US Fed rate target rate. On Wednesday, April 13, you could see the graph below of how the probabilities for different interest rates as of December this year have changed over the past twelve months. As recently as November, the discounted probability was only one and a half percent for a policy rate of over 1.25% in December 2022. Now, four months later, the consensus is that inflation is not transient after all but must and will be fought by the Federal Reserve. The Fed Funds futures market now counts for one hundred percent with at least 2.00% in key interest rates.

In just about a quarter, the situation has thus gone from no one believing in more than 1.25% policy rate to everyone counting on at least 2.00%. As recently as two days earlier, 80% actually believed in at least 2.50%.

It's a real change of scenery for monetary policy in just a few months, but what does it really mean for your investments? What effects does the interest rate movement have on shares and commodities and are the effects lasting? Can 100% probability be reduced or eliminated as easily as it arose? If most of it was due to the war in Ukraine and the repercussions on oil prices and temporary logistics problems, perhaps the situation can be quickly reversed, and then suddenly 100% is not 100% anymore, right?

Source: CMEGroup.com

If you look closely at the graph, you see that interest rate expectations rose sharply at the outbreak of the war, fell just as quickly when the war seemed to end quite quickly. After that, expectations rose to new records, but have fallen slightly again in recent days. I interpret the pattern as meaning that inflation has been increasingly permanent since September 2021, and that the war in that context is only temporary noise. Furthermore, an end to war does not mean that embargoes and sanctions suddenly disappear. No, several of Russia's energy customers have now decided to reduce their exposure once and for all.

In addition, I believe that the inflationary effects of the war impulse have triggered a domino effect with a long-term effect on prices. The economy was already sensitive and ready for inflation at the slightest disturbance, due to covid stimulus money in the system. The Fed had already baked various problems into the cake and now Russia just put it on the stove, but probably anyone or anything could have done it. The economy was the opposite of antifragile. It was hyperstable, as far from equilibrium as a Russian soldier in Ukraine.

I also read the statements of the Fed members that they have really decided not to fall further behind the curve than they already are. With 8.5% and a rapidly rising inflation rate, the Fed cannot take a chance on restraint with the increases. Then the Fed would risk even higher inflation rates without having had time to start any measures. With increases to 2-2.5% interest rates before the end of the year are already fully discounted in the Fed Funds futures, the Fed also has the market's mandate to increase. The question, however, is what the stock market can de facto handle, and which industries perform best and worst.

After only one increase and with eight 25-point increases ahead of us this year, I do not think that expensive technology shares have fallen clearly. Nasdaq is only 16% lower than the peak in November before interest rate expectations began to rise, and that is after only a single actual increase of 25 points. The giants Microsoft, Amazon, Alphabet and Apple have all performed better than Nasdaq, so there is a big downside if, for example, reallocations in risk parity strategies lead to outflows from index funds. Then it is the index leaders who can start working to catch up with the smaller tech companies that have already fallen a lot.

It is not just technology companies that can get tough in 2022. When the Fed raises interest rates quickly and a lot, it means in practice a choice between inflation and recession. More expensive loans, higher commodity costs, higher wages for skilled labor, deglobalization and logistics challenges for international companies will mean significant obstacles for, for example, engineering companies and non-durable goods such as sporting goods, house renovations, white goods and consumer electronics. With a Swedish inflation figure of 6.0% on Thursday (April 14) and a sharp rise in the US CPI over the past six months, consumers must prioritize their consumption for fewer and cheaper products, in addition to a small group of essential goods and services.

It is not obvious which companies or industries will be the winners in a stagflation scenario that takes over right after pandemic restrictions and war in Europe. Many, for example, have a pent-up desire to travel; but can enough people both afford and also have not had time to change their leisure habits and views on traveling? Will Netflix get through its price increases or will customers go to HBO, Disney or Discovery then, or perhaps streamed entertainment in several different channels will be prioritized over travel? One thing, however, I think is difficult to get away from, and that is that we have to live with high energy prices for a long time. Of course, weather and season will play a role in the short term, as will a weaker economy due to interest rate increases, but in the background, oil shortages continue to drive the price trend upwards.

Right now, the recession anxiety is being manifested in the share prices of engineering companies, car manufacturers and chemical companies, while oil companies such as Conoco Phillips are holding back the downward trends. It makes many investors think that the recession will drag down the oil companies as well. However, I think the equation looks different there. Oil companies are still fundamentally cheap at this level, and prices have already been kept artificially weak due to ESG considerations. But when technology, workshop and rare buy shares are to be sold, you have to rotate into something. For the really big money, expensive Walmart and power companies are not enough, ie classic defensive companies. Then there are only the oil companies and mining giants like Rio Tinto, as well as new energy companies like Vestas Wind. Maybe even the uranium companies, despite their current minimum stock market size.

Once again, I note that energy and raw materials are the only truly rational places for big business this year: big enough and cheap enough. War and inflation also make assets even cheaper in relative terms, which can drive a rotational flow into the sectors. Smaller investors can of course also invest a little in the junior companies around the mentioned companies, ie in smaller uranium companies, electrification material companies and gold companies (both seniors and juniors).

Please remember that any forecasts mentioned in this article are not a reliable indicator of future performance.

06/02/2023 01:40:59

 

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