(Monday Market Open) Just when you thought it might be safe to forget about the Middle East for a while, it comes back to bite the market.
Summer was pretty quiet in the region after a tense spring, maybe giving people a false sense of security. Now, with half of Saudi Arabia’s crude production disabled by an attack over the weekend, the spiral in crude prices reminds everyone just how much impact this faraway place can have right here at home. The once sleepy crude market jumped almost 10% early Monday and stock futures indicated a moderately lower open.
Generally, though, things seem to be holding together relatively well so far Monday considering the crude supply shock over the weekend. Stocks overseas were lower, but not dramatically. And as U.S. markets prepared to open, stock futures were off their lows.
It helps, maybe, that crude prices were low to begin with, so even a 10% rise only takes them back to levels they were at last spring. At the recent price of $60 a barrel, U.S. crude is way below last year’s peak of $75. There also seems to be plenty of supply for the moment, especially with the U.S. ready to dip into its reserves. Gas prices remain well under $3 this morning across most of the country.
The main issue with rising crude prices is the potential impact they can sometimes have on economic growth. The consumer who’s been so resilient the last few months might not be if it starts costing $3 a gallon or more to fill up the SUV for a trip to the big box store. Costs also could rise for transport companies and for companies that manufacture products overseas and bring them here by freight. Those costs could ultimately get passed along to consumers already reeling from higher gas prices.
The other thing this situation creates is uncertainty, something markets generally hate. There’s been some saber rattling since the attacks, and this sort of thing tends to put investors into caution mode. That could mean the bonds and “defensive” sectors they abandoned last week for value and momentum stocks might suddenly look enticing again. The bond market rallied to start the new week, with 10-year yields falling back to 1.84% after topping 1.9% on Friday.
It’s still early days with this particular crisis, and how things develop in the very near future could have the biggest impact. If Saudi Arabia gets production back to normal relatively quickly and the U.S. and Iran step back from confrontation the way they did earlier this year in the clash over Gulf shipping, maybe this turns into a blip. That’s a best-case scenario, but even then, more geopolitical risk might stay built into crude prices.
Another possibility—short of any sort of military fireworks—might be Saudi Arabia taking longer than expected to get back on track, prices staying high, and already weak European and Asian economies taking a hard hit. These regions depend a lot on Persian Gulf crude, while U.S. imports from the region are only about one-third of what they used to be. Any sign of recession in Europe and Asia would probably mean even slower crude demand growth, meaning ironically this event could ultimately send crude prices lower. Probably not right away, though.
Before the attack in Saudi Arabia, markets here were on pretty solid footing. The week opens with the Dow Jones Industrial Average (DJI) on an eight-day win streak and U.S stocks up three weeks in a row. That followed a four-week losing streak. At the same time, benchmark U.S. 10-year Treasury yields still have the 2% mark not far above their heads after falling below 1.5% just 12 calendar days ago.
There’d been a huge shift in sentiment in a very short time, helped by signs of progress on the trade front and mostly decent U.S. economic data. Aside from geopolitics, everything this week leads up to Wednesday’s Fed meeting conclusion, where investors widely expect another rate cut.
It’s likely the Fed has already contributed most of what it could to the rally even before it meets this week, because another rate cut is widely expected and probably built into the markets already. However, CME futures now price the chance of a cut at around 80%, down from well above 90% several weeks ago. Typically, if you’re at 80% going into the meeting, it’s likely the market is on the right track. It’s dangerous to get too complacent, however, and if the Fed surprises on Wednesday without a cut, it could send stocks heading back down under the 3000 level again.
Even if the Fed does cut rates, what Fed Chair Jerome Powell says about future plans at his press conference Wednesday could be chapter two in the Fed story this week. Many Fed officials have already made it pretty clear they don’t think even a 25-basis point cut is needed now, so it might be harder to build the case for another one as soon as the October meeting. The market projects chances of well below 50% for a third cut in October after the Fed cut in July and the anticipated cut this week.
Volatility finished last week down at levels last seen in July, at below 14 for the Cboe Volatility Index (VIX). That was then, this is now. VIX is back above 15 to start the new week.
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FIGURE 1: CHANGE IN THE WEATHER? This one-month chart shows how quickly things changed once the calendar turned to September. We see transport stocks ($DJT-candlestick) start emerging from their August slumber and gold (/GC-purple line) sag from its recent six-year highs. It could all go hand-in-hand with hopes for a trade deal and a slump in the bond market. Data Sources: S&P Dow Jones Indices, CME Group (NASDAQ:CME). Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Behind Factory Doors: On the data front, tomorrow morning brings key industrial production data for August. With manufacturing declining around the world, U.S. factories are under a microscope for any signs of the contagion possibly spreading. It’s been a tough few months for this industrial production. It declined 0.2% in July after falling in January, February, and April. Capacity utilization, also due Tuesday morning, was below long-term trends in July and could also get a close look. Another decline in the headline production number could probably raise some eyebrows and maybe cast a little doubt on just how healthy the U.S. economy might be.
Speaking of production, there’s been what research firm FactSet calls a “dramatic slowdown” in global manufacturing activity since the end of 2017. Some of the countries where manufacturing fell from high levels include France, Canada, the U.K., Japan, and yes, the U.S. It might be prudent for investors to keep watching those manufacturing PMI data reports pretty closely in coming months to get a sense of whether the new monetary stimulus announced in Europe last week has any impact.
Riding the Cyclicals: With all the talk last week about how value and small-cap stocks led the rally, you might have missed one important takeaway: The mid-September rise back toward all-time highs actually was a cyclical affair. Sectors like Financials, Industrials, Materials, and Energy topped the charts. Transports also flew high. As an analyst on CNBC noted Friday, these aren’t the type of sectors investors tend to turn to when they’re worried about economic weakness. They tend to be where people park their money when they feel bullish about economic prospects, so if investors are right, that could bode well for the months ahead.
There appears to still be lots of cash on the sidelines and in the bond market (despite the recent sell-off there), so arguably the rally could have legs. On the other hand, lack of forward progress on the trade picture could keep the market range-bound. If the S&P 500 (SPX) manages to make a series of closes above the old high near 3027, that could potentially provide a technical spark that helps convince more people to buy.
Piggy in the Middle: Give our porky farmyard friends some credit for the recent slight thaw in trade relations between China and the U.S. It’s confirmed now that China will relax tariffs on U.S. pork products, a move that Briefing.com explains is “likely being done out of necessity as the country grapples with a significant shortage of pork, which is a staple food in China.” Last week, CNN reported that the shortage has grown so bad that China’s cities are starting to eat into their emergency reserves of frozen pork. The world's largest pork market has been ravaged by an outbreak of African swine fever, and it's lost more than 100 million pigs in the last year. Meanwhile, the U.S. hog herd hit a near 80-year high in Q2 at 75.5 million head, according to the U.S. Department of Agriculture (USDA). Are ham sandwiches going to be on the lunch menu when Chinese negotiators meet with their U.S. counterparts in Washington next month? Couldn’t hurt.
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