Oil Shock Returns | Inflation Reignites | US-China Divide

Andrew Sarna and Vanessa Hui break the resurgence in oil markets, inflation fears reigniting, and why the U.S.-China relationship remains stuck in a stalemate.

WHAT TO LISTEN FOR

00:28 Why is the rest of the world selling off while the US holds on?

03:39 Three months, a closed strait, and oil at $110 — why is this only hitting markets now?

07:51 The US-China Summit promised a lot — so why did it deliver almost nothing?

09:29 The three things every investor needs to take away from this week's headlines

CONNECT WITH ANDREW SARNA

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CONNECT WITH VANESSA HUI

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This podcast is for informational purposes only and does not constitute investment advice. Views expressed are those of the speakers and should not be relied upon for investment decisions.

Transcript

Andrew Sarna (00:04):

Welcome back to Forthlane's Off the Charts podcast, where every two weeks we cover three market headlines that matter. I'm Andrew Sarna, portfolio manager.

Vanessa Hui (00:12):

And I'm Vanessa Hui, senior client advisor.

Andrew Sarna (00:15):

Three big things to cover this week, oil markets, the collateral damage of those markets, and US-China Summit.

Vanessa Hui (00:28):

Okay, let's dive into our first topic. US markets were up ever so slightly last week, while markets across the rest of the world were mostly down. What's driving that disconnect, Andrew?

Andrew Sarna (00:40):

There's two big things that really are driving markets right now. One, the AI trade, and then secondly, oil. I characterize what we're seeing right now as you can't paper over the real world, meaning Trump can tweet and tweet and tweet, but eventually physical oil matters and the physical world is what is going to drive markets. I feel like the conflict is hardly making headlines anymore. The Straiter Hormuz remains closed and we are coming up to almost three months of the conflict of what was supposed to be a two-day operation if everybody remembers. Additionally, over the weekend, Trump's tweeting memes again. He tweeted a picture of it was the calm before the storm with some battleships in the background. And on top of that, UAE reported that Iranian proxies attacked a nuclear facility using drones. If anything, it looks like negotiations are going in the wrong direction.

(01:36):

But yet again, Trump tweeted before the open that they had made an offer to remove Iranian sanctions. So you continue to see the US administration trying to calm markets, but eventually physical markets matter. So when we look at prices, front month Brent is back to $110. The highest level of reach throughout the conflict was 116 and WTI is back over a hundred. Eventually, you're going to see a situation where we get demand destruction. And while we're on the topic, interestingly, last week it was disclosed that US producer Diamondback Energy had bought options to sell the price difference between W2EI and the globally traded brand crude at around a $42 difference. This means they're hedging against a US export ban where the US would restrict energy exports to the rest of the world. This would be fairly unprecedented. This would create a US price for oil and a price for the rest of the world.

(02:34):

This would broadly hurt the rest of the world since the US is energy independent and they would retain more oil while it would exaggerate shortages internationally, causing prices to rise. So good US, bad international markets. It also hurts US energy producers disproportionately because they're forced to sell at lower prices. This is a very interesting dynamic because it could take the taco off the table, meaning the US has a higher pain tolerance than everyone else and it could prolong how long the strait is closed. But again, markets can only stay resilient for so long and eventually we're going to see shortages and this is going to push inflation higher around the world. So in summary, oil markets are still a problem despite the lack of headlines and I think this is one driver of why we saw especially international markets sell off last week.

Vanessa Hui (03:39):

So Andrew, the state has effectively been closed for almost three months now. Why is the market reacting now?

Andrew Sarna (03:47):

So on oil prices, there's two things we're watching. One, shortages. So we had Modi last week asking the people of India to begin rationing fuel and carpool and other sort of methods to reduce demand for oil. So I would characterize that as shortage is forcing the hand of various different countries around the world. And then on top of that, you have high prices driving demand destruction. So it's just at some point oil prices become too high that we're going to decide not to make things because it's uneconomical. And then another part of it is it's starting to show up in the data and the data is driving markets. So we had two inflation releases last week, consumer price index and producer price index. CPI was up 3.8% year over year from 3.3%. So we are a hair away from a forehandle on inflation and then PPI, which going into the year was at 3%, is now at 6%.

(04:48):

So we are starting to see these high oil prices begin to flow through the economy and the data is clearly beginning to accelerate. Looking under the surface at the CPI release, it is mostly energy related categories surging, fuel oil, other motor oils, airfare, gas, and policymakers can understand that you know what? There's sort of a binary nature to what's happening in markets. If they open the straight hormones, sure it will take a bit to rebuild inventories, but a lot of that could be transitory if the strate was opened overnight and things could normalize pretty quickly. But you're also seeing other measures beginning to accelerate. So owner's equivalent rent, shelter is up 3.3% year over year up off the lows. The risk is that these prices begin to ingrain themselves in the economy and start impacting stickier categories that are not transitory such as wages. Not that they're there yet, but we're starting to get closer because it's like a situation, costs are going up so you ask your boss for a raise and then you get this wage price spiral that pushes inflation higher and engrates itself in the economy.

(06:04):

More from a market perspective, what drives markets is these high inflation prints begin impacting bond markets. 10-year yields were up almost 20 basis points in both Canada and the US last week. The US 30 year is a hair away from its highest level since 2007. The bond market could start mattering for equity markets once again. There are two historic parallels that I'm thinking about in this situation. One, the 1970s double wave of inflation. If you've seen this chart initially, I dismissed that, no, this would never be possible because in this instance in the 1970s, the second wave was caused by an oil shock. Well, what seemed impossible is seemingly almost more likely right now. And then the other parallel I'm seeing is 2021. You have this period of tech euphoria not dissimilar to what we're seeing in the AI complex right now, which was eventually derailed by rising inflation and bond yields.

(07:02):

And if everyone can remember back to 2022, that was not a very fun year for equity markets and broader risk market investors. Equity markets are also vulnerable on top of that. They're priced very richly. So if you look at forward PEs, KP ratio, Buffet indicator, all of them are really at all time high. So the market remains priced to perfection as it has been for a while, but you're starting to see the data that there's going to be more and more pressures on this and because of that richness priced into the market, there isn't a huge margin of safety. So I'm not quite bearish yet, but could easily see things getting derailed by high bond yields/inflation.

Vanessa Hui (07:51):

Now for our last topic, one of the major headlines last week was the US-China Summit. Should we view that as a meaningful development or mostly political optics?

Andrew Sarna (08:03):

Yeah. In the background we've had these tensions between US and China. Of course, with everything else going on in the world, it's taken a little bit of a backseat, but this summit, which was largely anticipated, was mostly a nothing burger. There were a couple headlines in an effort to pump markets as the US administration has been doing, but the only specific deal announced out of the summit was a commitment by China to purchase 200 planes from US aircraft manufacturers, Boeing. Still think US realizes that outsourcing manufacturing to China hollowing out the USs and the West industrial base was a mistake. And if you think about it from a game theory perspective, Trump really just wants to minimize any negative actions ahead of midterms. Trump wants to maintain as much peace as possible. So regardless of whether there is a deal or not, this summit was largely always going to be positive headlines.

(09:01):

It was always going to be cordial. I continue to think that the overarching strategic nature of this is they still want to decouple, but I think day by day it's becoming increasingly clear how difficult of the task that is going to be because I mean, this has been a priority from the administration for years now and we've seen hardly a major impact in the US's ability to reshore manufacturing outside of semis.

Vanessa Hui (09:29):

So to summarize, despite making fewer headlines and the fact that the Straits of Hormuz have been effectively closed for almost three months now, oil prices continue to matter for broader markets, rising inflation and bond yields could derail bull markets. And lastly, US-China relations continue in its salemate while tensions remain high.

Andrew Sarna (09:56):

That's it. Thanks for listening. Like and subscribe on your favorite podcast provider.