From a bull’s perspective yesterday’s gains in the oil market actually feel like losses. Friday’s massive expiry related price falls was meant to be a one-off and the market was expected to recover yesterday. It duly did so in the early part of the trading session. The strength that took Brent $1.60/bbl above Friday’s settlement at one point was greatly aided by reports that Saudi Arabia is pushing not just for a simple roll-over of the current deal but also for deeper cuts. The logic behind this move is based on the upcoming Aramco IPO and on the dismal supply/demand forecast for 1H 2020. The simple fact is that without stricter market management global oil inventories would rise in the first half of next year.
The market was on its way to recoup the ground that had been lost at the end of last but then the US woke up. Life moves in cycles and, it appears, so does the mood of the US president. Yesterday he re-visited the issue of import tariffs. Using the strong dollar as an excuse he restored tariffs on steel and aluminium imports from Brazil and Argentina and in the same breath urged the Federal Reserve to cut interest rates further. France could not escape the president’s ire either as his administration is proposing 100% import tariffs on French goods worth $2.4 billion including wine and cheese as a retaliation of the digital services tax imposed on, amongst others, US technological giants. The US Trade Representative Office suggested that further tariffs could be introduced on products from countries like Italy, the UK and Spain as the WTO dismissed EU suggestions that it no longer subsidises Airbus.
Add to these the unexpected fall in US construction spending in October and the shrinking factory activity in November and it becomes obvious why stock markets trended lower yesterday. When equities weaken oil usually struggles for upside traction hence the retreat from the morning height. WTI finished 79 cents/bbl higher at $55.95, way below last Thursday’s closing level of $58.11/bbl. Brent registered a daily gain of 43 cents/bbl and settled at $60.92/bbl. Given the upcoming OPEC meeting, Aramco IPO, the UK elections and the December 15 US tariff deadline on China volatility will be the motto for coming days and weeks.
Equities are overvalued compared to oil
The fragile state of the global economy is well publicized. Growth estimates have been constantly revised downwards and other financial data also provides with some dismal reading. The latest OECD estimates forecast the slowest growth of the global economy for 10 years. This year and next the expansion is expected to be 2.9%, down from 3% two months ago. Chinese growth will fall 5.7% in 2020 from 6.2% this year and to 5.5% in 2021. The US economy that is to grow by 2.3% this year will slow to 1% in 2020. Manufacturing and service figures are equally disheartening. We learnt two weeks ago that eurozone composite PMI, which includes both the service and the manufacturing sectors fell to 50.3 in November and is bordering with contraction. In the UK the same figure was firmly below 50 last month. As mentioned above the US manufacturing sector contracted for the fourth consecutive month in November.
Stock markets, however, are refusing to take notes or to get concerned. The MSCI Global Equity Index, albeit 1.2% off the highest ever print reached last Thursday, shows a year-to-date return of 19% The S&P 500 index has jumped 24% this year and is up nearly 50% since Donald Trump became the US President.
One might conclude that this is a curious development as it is exactly the US protectionist trade policy that is negatively impacting economic growth, not only back home but globally. If this is the case the question arises as why stock market investors are so optimistic. We can think of two reasons: firstly, they expect the trade dispute to be resolved latest next year in the run-up to the US elections. Secondly when money is cheap (interest rates are stubbornly low and in some cases they are even negative) the appetite to invest in risky assets would grow.
Oil clearly does not fall into this category. Since the 2007-2008 financial crisis, for example, the global equity market more than tripled in value whilst oil is less than 80% above the 2008 low. Not only struggling oil demand growth caps any attempt to send prices higher but the impressive jump in non-OPEC and US production also acts as a break on inventors’ sentiment.
The net result is that oil is now relatively cheap compared to stocks by historical standards. Roughly 51 barrels of Brent crude oil is worth as much as one unit of S&P 500 index. This proportion averaged below 40 in 2018 and was as low as 20 in 2014. It is not entirely clear how investors would react if a trade deal between the US and China were struck or Donald Trump lost the next elections. They might greet either of these developments with uninterrupted enthusiasm providing further stock market support. The normalization of trade relationship would be welcome news for oil demand, too potentially pushing oil prices higher than equity prices. In case of a fall-out or full-blown trade war equities have more to lose, simply because they have gained more over the past few years. Under the latter scenario they would fall harder than oil, especially if the swing producers of the oil market lived up to expectations.
In either case we would expect some significant retracement in the aforementioned ratio. It has averaged around 45 so far this year and the momentum will probably not be maintained in 2020. When the final outcome of the trade talks gets clearer we will likely see equities rise slower or fall faster than oil. Only an antagonistic row between oil producers would potentially upset the above theory. Barring any outrageously negative supply-side development oil will likely perform better next year than equities, especially in the second half of 2020.