If You Watch Only One Indicator Right Now, Make It This One

High oil prices are weighing on economic activities; central banks are ready to hike

If we have learned anything from markets, it is this simple observation: High energy prices cause recessions. 

The logic is simple. High energy prices dislocate spending normally reserved for other activities. This leads to a self-reinforcing economic contraction, aka a ‘doom loop’. 

You can see this relationship from the crude oil chart (since 1966, overlay with recessionary periods in shades). The lead-lag correlation between high oil prices and recessions is identified almost instantly. 

Source: fred.stlouisfed.org

Moreover, higher energy costs will prompt central banks to hike rates quickly (a la Volcker style). Significantly higher borrowing costs, like mortgages, floating debt interest, and refinancing costs, all suck spending power out of the economic system. 

Today’s Financial Times, for example, observes this trend (23 March): 

Traders in the swaps market are now fully pricing four quarter-point interest rate rises by the Bank of England this year. Before the conflict began, investors were expecting two cuts.

The net result is a +6 (from -2 to +4) hike in the policy rate. This is a drastic re-rating of the monetary policy as a result of the volatile situation in the Gulf.

No wonder the UK ten-year gilt yields spiked up to its highest level in decades. Traders are betting that the Bank of England will have no choice but to obey the economic rule dictated upon it. 

And the messy situation there is far from being resolved. 

As a matter of fact, the US President has upped the ante with ‘deadlines’ and firm time scales. In traders’ minds, these are arbitrary – but hugely important – political red lines that, once crossed, will bring about a sharp deterioration of the military engagements. Boots on the ground to take out launchers; ‘mission creep’ to defend the Strait of Hormuz. These are complicated options that will cost money and lives. Not to mention a huge jump in market uncertainty. 

The US Small-Cap Index, Russell 2000 Index, has entered into correction territory last Friday. The sector peaked in late January and now is now trading 10 percent below its peak.

At this rate of decline, the blue-chip S&P 500 Index and technology-focused Nasdaq 100 may soon follow suit. Both are down by 7.1 and 8%, respectively, from their all-time highs. Another bout of jittery selling would kick both into a corrective wave.

The more burning question every investor is asking: Will stocks enter into a bear market?

The answer is clearly a ‘yes’ if: 

1. oil and gas prices continue to stay high, and
2. central banks start to hike rates in a rapid fashion.

These actions will be very damaging to consumer spending, corporate financing and government borrowings. Virtually all Western governments are racking up budget deficits; higher interest rates will just make budgeting far more difficult politically. Taxes may even have to go up further, which normally causes sitting governments to lose elections. 

Did you know that the US is already paying $1 trillion in annual interest expense? 

Missiles are very costly, and the White House is seeking an additional $200 billion to fund its Iran engagement. All these will just pile onto the burgeoning American national debt – currently at a staggering $39 trillion and counting (see www.usdebtclock.org/)

Investment Implications

Given the above backdrop, it seems that President Trump has just done a ‘TACO-lite’ on Monday (23rd). 

The commander-in-chief told the world that he had ‘productive talks’ with the country that he had just bombed relentlessly for three consecutive weeks. 

Stocks immediately rallied, as did gold, silver and Bitcoin. On the other hand, crude oil, slumped. The swing from ‘risk off’ to ‘risk on’ happened in minutes, much to the relief of investors. Trump is realising that oil at $100 will deplete his political capital at a furious rate. 

The next critical step, however, is that these talks must lead to a political settlement that opens up the Strait of Hormuz. Without which, energy supplies from the Gulf region will run dry in weeks, leading to energy rationing in many countries.

Will this settlement happen? Given Trump’s TACO habits, he may well pull back from the costly engagements in the region. Obviously, a victory of some sort will be declared. Bombing will be lifted.

But this doesn’t mean that all is smooth sailing from here.

An oversold rebound may take place this week, aided by short covering. Bears will be keen to take their recent profits.

But should we go ‘all in’ once the Iranian conflict subsides? Perhaps not. Who knows what other episodes the US president has in mind now. Investors are jittery and rightly so.

Investors should watch 52-week Highs

If you intend to buy amidst the ongoing relief rally, letting the market guide the process may be a good idea.

One useful criteria to use is the ’52-Week Highs’ list. 

Following a sharp correction, stocks that rebound quickly back to new highs are the ones that are being accumulated. These stocks are ready to run up. In contrast, you don’t really want to buy securities that are at multi-year lows and are still sinking. 

Let me give you an example from last year. Stocks declined sharply in April due to the ‘Liberation Tariffs’. But some stocks recovered much faster than others. 

Microsoft (MSFT) hit 52-week highs in late May at $470 continued to drift all the way to $550. Relative strength dictates some exposure here on a trading basis. 

The latest correction will present similar opportunities. Just keep watching for relative strength performers/52-week high hitters.