Macro-Economic Environment
One would have thought that there had been a major shift in Fed policy, or some other fundamental driver that has propelled the largest monthly bond market rally in 40 years. Not to be outdone, there has also been a rally in the S&P 500 in excess of 10% just over the last few weeks. While we struggle to find the exact reasons behind these powerful moves, we are of the mindset that the rally in both is most likely due to two old crowd favorites: liquidity and sentiment (risk on).
A look at the chart below shows the close correlation between an amalgamation of liquidity inputs (mostly net reserves held within the system) and the S&P 500. The liquidity index is somewhat convoluted in its construction, but the bottom line is that the upturn in the liquidity line (blue) denotes cash coming into the markets that had previously been dormant. One significant source of this liquidity has been the RRP (Fed “Reverse Repo” facility), which has been drawn down by $1.6 Trillion, thus representing a huge influx of cash into the system. This cash, in turn, finds its way into funding markets and, ultimately, into stock and bond markets.
While these liquidity measures have been turning higher, market sentiment (risk on) has also shifted radically in the last several weeks as both stock and bond holders believe we’ve arrived at the end of the Fed’s tightening cycle. This has been predicated on the general narrative that the war on inflation has been won. We are definitely not in that camp however (see Commodities/Energy section), particularly given that there are myriad of examples in the past where inflation was on a downward path only to flare up again.
One reason we suspect this rally is liquidity and sentiment driven is because of the relative “junkiness” of this move. Some of the most speculative assets have been the outperformers, with ARKK (Ark Innovation ETF) moving 33% higher and Bitcoin up by 10% during November. Additionally, High Yield ETFs experienced their largest inflows since 2020. Similar historic moves in the most speculative of sectors occurred during periods where liquidity was turning up (see 2020 on the chart).
Suffice to say, we are not confident that the rally in either the bond or equity markets will continue. Our skepticism is based largely on the fact that the victory celebration over inflation has been premature, and that this will become apparent in the months ahead. Any stickiness in inflation will become extremely problematic for the Fed, given that 2024 is an election year and it will want to err on the side of being “dovish” when conducting policy.
Takeaways: The dramatic moves in capital markets over the last several weeks are emblematic of a significant shift in liquidity meeting a broad-based change in recessionary caution. We have seen many such confluences throughout the last several years. Each instance was resolved with a continued march higher in rates amid inflation persistently above target.
Commodities/Energy
When it comes to resiliency, Venezuela may not be what initially comes to mind. However, as far as political survival and oil production are concerned, it is near the top. Maduro, a former bus driver, came to power after the death of Hugo Chavez in 2013. Maduro’s volatile Presidential tenure has closely mirrored the trajectory of the country’s oil production. The aftermath of a failed coup, and the onset of Covid, coincided with the nadir of Venezuela’s oil output - down to ~300,000 barrels/day (from over 2MM barrels/day in 2017).
Fast forward three years and Maduro has out-maneuvered his U.S. counterparts and waited out any economic sanctions. The relaxation of oil export sanctions in exchange for “conducting fair elections” in the South American country actually has much more to do with our own upcoming election. Oil production out of Venezuela, currently at ~850,000 barrels/day, is a welcome benefit in helping to suppress oil (and gasoline) prices.
Venezuela may try and take a shortcut in getting to 1MM+ barrels of oil production. It is reported that their land (and offshore) dispute with neighboring Guyana is heating up, and the primary reason for this new animosity revolves around relatively recent oil discoveries. Guyana, the brightest star in offshore development, has ramped up production significantly through JVs with the likes of Exxon to an estimated 620,000 barrels/day. Despite being settled by treaty in 1899, Venezuela is holding a referendum next week on whether to “reclaim” disputed lands (which make up ⅔ of Guyana’s territory).
Another supply chain issue is proving both problematic and inflationary. Congestion in the Panama Canal remains extremely high due to the driest conditions experienced in decades (man-made fresh water lakes feed the canal). There are approximately 95 vessels on either side of the canal awaiting passage, which is an improvement from approximately 200 in August. Disneyland-esque, line-jumping “fast passes” are being traded for up to $4MM. Whether you’re paying these fees or waiting three weeks to traverse, items within containers will ultimately be more expensive, late, or both, according to Maersk - the largest individual user of the canal.
Naturally, remedies are being considered, including rerouting through the Suez Canal, Strait of Hormuz and the Bab el-Mandeb Strait (when applicable). With the Israel/Hamas conflict raging, all of these waterways pose their own particular problems. Especially concerning is how to provide adequate security against parties targeting Israeli-flagged vessels. Once again, whether it’s bolstering security, shipping via longer routes, or paying added insurance costs, the end result is that this is all inflationary and out of the purview of monetary policy.
Takeaways: While the rate of inflation has receded as expected, the route to the 2% target from here is exponentially more difficult. Bottlenecks and alternative routes create energy (and broad commodity) delays and higher prices. A potential military conflict between countries representing the largest oil reserves in the Western Hemisphere is also something few are factoring in.