Oil and Inflation Make for an Unpredictable Mix

After that surprising jobs report, new fighting in the Middle East and big stimulus announcements from the Chinese government, the two main themes I'm tackling this week are oil and inflation. 

Oil Bubbles Up

Let's start with oil. The probability that we see oil production targeted as part of the escalating fighting in the Middle East has increased. I discussed this in a recent webinar – "Risk of Further Escalation in the Middle East" – that sought to answer some of the uncertainty managers are facing when dealing with the conflict. We believe oil  – as in disruptions to oil supply or production – would have the largest impact on the global economy.

At its most simple level, there are two main reasons to expect further escalation, which could include targets connected to energy production and distribution.

From a military standpoint, Israel has had a series of successes. The attacks using pagers and walkie-talkies seemed to do three things:

First, attacks caused actual injuries and deaths attributed to those devices exploding. Second, it forced more “in person” meetings to occur, which have in turn been attacked. And third, while not only killing and injuring many with exploding pagers and walkie-talkies, the attacks also had a massive psychological effect. Enemies of Israel must wonder about how much information Israel has on them, such as whether their whereabouts are known at any given time, in what other ways has Israel potentially infiltrated their organizations, and are they at risk of some non-conventional attacks? This fear is relatively new and is likely an important part of the calculus for Israel’s next steps.

From a military standpoint, Iran did not seem to accomplish much with its ballistic missile attack. Yes, some got through and hit military targets, but the vast majority were intercepted or landed in areas causing minimal damage to either people or infrastructure. 

If the attack was meant to signal to Israel that its unsafe and subject to retaliation and retribution, it is difficult to see this attack as having been very successful. If the attack was meant to reassure the proxies that their proxy leader is all-powerful and could easily protect them, that likely failed, too.

The combination of those two factors is why escalation is likely, even in the face of pressure from many countries to cool it.

Inflation Now Part of Fed’s Calculations

Friday’s job report was so strong that the Fed can no longer just look at jobs data, which has been its modus operandi for the past few meetings. It's very important that we got the upward revisions we were expecting. But another “beat” on the headline data (but with downward revisions) would have been easy to ignore, but this one isn’t.

So, with the employment data so much stronger and with chatter about the Sahm “rule” dying down, the Fed is likely to be more cautious.

While I am not particularly worried about inflation, there are some things that we should be watching for:

• The risk of higher energy prices from any major disruption in the Middle East (with Russia and Ukraine also a potential risk on that front).

• Rising commodity prices across virtually every commodity. If you set the time frame to one-month, all the commodities under energy, metals, and agriculture (which surprised me a bit) are up. The NYMEX Henry Hub natural gas futures contract is up a whopping 33% in one month. Copper (aka “Dr. Copper”) is up 11% along with aluminum and nickel. While rising commodity costs can take time to filter into prices paid by consumers, it is worth watching.

• China stimulus. Who knows what impact Chinese stimulus will have on domestic consumption, but if it does, that could put upward pressure on commodities and even finished goods. It is clear that some of the rise we’ve already seen in commodity prices is in anticipation of that stimulus, so the stimulus will really need to work well to continue to put upward pressure on prices, but my base case is that it will work. 

My view is that the Fed had tilted to being 90% fixated on jobs and now it has to increase the weighting on inflation risks, of which there are several. 

While the market has tempered Fed cut expectations (down to four cuts in the next four meetings from six cuts in the next five meetings), I think it will come down further.

Bottom Line

Expect moderately higher yields across the curve. The Ten Year should drift toward 4.1% as we head into Wednesday’s auction, after which it should find some support. 

As for equities, I do think the re-opening of China’s markets this week, having been closed for Golden Week, will impact U.S. markets (especially if it doesn’t hold onto big gains already priced in). While I think the stimulus will work over time (and the government will add more, if it isn’t) I’m reducing my positions in the Large Cap China fund FXI and the China Internet fund KWEB ahead of that reopening. I think markets may have gotten ahead of themselves with markets closed and being forced to trade in “a vacuum” of information for a full week, which has seen prices rise over 12% as of Friday’s close, since Chinese markets closed on Sept. 30. 

I was surprised by how well stocks responded to the 10-year nearing 4% on Friday. Stocks threatened to fade several times, but decided to ignore the move in yields (good news was good) and to downplay the risk of escalation in the Middle East. This week will be interesting, but I expect the risk is skewed to bigger downside moves, as many of the issues discussed here (war, inflation, and the neutral rate) get coverage and traction.

Finally, as for the election, I’m largely ignoring the election with “gridlock” seemingly priced in, but as the date nears, we should see some more volatility surrounding election, polling and betting market headlines.