Indiana Trust Wealth Management
Investment Advisory Services
by Clayton T. Bill, CFA
Vice President, Director of Investment Advisory Services
- The U.S. equity market, represented by the S&P 500 index, rose 2.6% this week.
- Last week, we noted that the bond market appeared to be sanguine on inflation diminishing in the coming years.
- This week, we consider evidence to support the bond market’s outlook including energy prices, supply chain loosening, and jobless claim data released on Thursday.
The U.S. bond market appears to be optimistic that inflation is not going to be much of a problem in the coming years. What is the evidence to support the bond market’s current consensus?
Much of headline inflation is driven by energy prices. While there has been an oil price shock with Russia’s invasion of Ukraine, less discussed has been the widening of the spread between oil prices and gasoline prices, known in the oil industry as the “crack spread”. This spread, the theoretical refining margin, began widening well before the invasion. A few market analysts recently opined that the spread may be structurally higher from here on out, implying that gasoline prices would remain high.
The last month has witnessed a dramatic narrowing of the crack spread, which households have experienced as lower prices at the pump. The crack spread has dropped from $60 to below $40 per barrel.
Chart: Skanda Amarnath, Bloomberg, July 21 2022
Why did this spread widen so much, and what is driving its rapid decline? It is almost impossible to pin this down, but it comes down to some combination of a decline in demand and what the economist Skanda Amarnath refers to as “frictional dynamics – a reallocation of refining flows, identifying most efficient solutions”.
Relatedly, gasoline futures are falling dramatically:
Chart: Conor Sen, Bloomberg, July 21, 2022
Other supply-side bottlenecks appear to be loosening. The microchip shortage which impacted the production of everything from cars to video game consoles may soon turn into a glut. Businesses up and down the supply chain raced to stockpile chips, and now they are drawing upon those reserves rather than placing new orders. "The global semiconductor industry is seeing rising inventory levels against the background of weaker end-demand expectations," said Kristine Lau, an analyst at investment research company Third Bridge. "Cuts to orders and demand-forecast reductions are becoming more widespread."[1]
Ports and shipping have been another source of supply chain woes. Good news there: the cost for shipping freight from Shanghai to Los Angeles, which had skyrocketed in 2021, has been trending down consistently since the beginning of the year.
Chart: Conor Sen, Bloomberg, July 21, 2022
The last bit of evidence on the side of the bond market’s expectation for lower inflation is not as cheerful: signs of a slowing U.S. economy in the labor market. Initial jobless claims rose this week. Although claims continue to be low relative to early 2021 and this data hardly shows an economy in “recession”, the trend is clearly on the upswing.
Chart: Renaissance Macro Research, July 21, 2022
The U.S. stock market rose on the higher-trending jobless claim data release on Thursday. Why? This dynamic may be described as follows, with a large margin of error: overly tight Federal Reserve interest rate hikes now mean a broad economic slowdown, which means lower inflation and interest rates in the future, which means less restrictive monetary policy from the Fed in 2023 and beyond, which is good for stocks in the medium-term, if the economic slowdown isn’t too fraught with peril. It is a tricky macro backdrop for capital markets.
[1] “Chip giant TSMC warns of ‘excessive inventory’ at clients”, CHENG TING-FANG and LAULY LI, Nikkei Asia, July 14, 2022
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