Econbrowser ran a post entitled “Dude, where’s my cheap gas?“. It has a few interesting charts indicating that it will take some time before the shale gas/oil revolution impacts prices at the pumps. I think there could be a bit more into that story and quite soon, too.
The chart below shows the spread between Brent and WTI oil prices.
This has stayed elevated for quite some time and for various reasons and it seems to me that the market is no longer paying attention to why this is actually happening. Many have been citing he Middle East turmoil as one of the reasons. While this is certainly a factor, why would we see that only in Brent prices? Firstly, Brent and the Middle East blend are not exactly substitutes. Secondly, we are not seeing that risk in any other market (have a look at the Israeli shekel or forward points in USD/SAR in Saudi Arabia). Finally, there is tons of new supply coming from Iraq and some African nations, replacing the lost output from Iran. In short, I don’t find the whole Middle East hypothesis plausible.
So if it’s not supply disruptions/changes then maybe it’s demand? If you go through the Chinese data (and seasonally adjust them), you will find that the dynamics is pretty decent. Moreover, for years everyone has been talking about Chinese urbanisation, which inevitably brings more demand for fuels (think of it as the copper-oil spread). We can’t be certain how far advanced in the process we are but things are progressing in the direction of less investments and more consumption.
Meanwhile, the world is fixated on declines in inflation, which are about to happen or are already happening. Have a look at the momentum in US core inflation (below, annualised rates).
There is almost nothing worrying about this picture unless of course you are a firm believer in the “what goes down, must go up” theory. In all likelihood the US inflation picture will not change in the coming months, particularly in the core. But what about the rest of the world?
Let’s not forget that vast majority of economies have experienced a significant drop in potential growth rates over the last couple of years. This means that any increase in growth could lead to inflation sooner than we think. Sure, many will say that it’s not just the growth rate that matters and we need to close the output gap first but the worry is that the world where productivity is on the decline any growth acceleration could be inflationary. Add to that a sustained supply shock and you have a recipe for a pretty decent repricing of interest rate expectations.
Now, I don’t mean to sound alarmist about inflation and I would not call myself a vivid supporter of people who call for repetition of the Weimar Republic (yes, Ambrose Evans-Pritchard, I’m talking about you…). But the prevailing way of thinking is that many countries will not need to hike interest rates for longer than you would normally expect simply because the additional carry would strengthen their currencies. This is particularly the case in emerging markets. The same emerging markets, for which the growth consensus remains pretty bullish…
Where does this leave us? Improving leading indicators, lower potential GDP growth rates, reduced productivity growth and possibly quite persistent upward trend in oil prices. For me these are crucial reasons to worry about bond markets in many (emerging) economies. In my mind they are certainly more valid than the US Treasury sell-off cliche, which dominates media and analysis.
How to trade this? Find a country with a significant trade deficit and improving growth outlook (e.g. Turkey) and be defensive there. Also, look for activist central banks (e.g. Israel) and be aware that those guys can and will move very quickly. Additionally, if you need to own bonds, go for short duration in higher yielders (such as Russia or Brazil). Finally, think if it doesn’t make sense to switch out of suppliers or industrial materials into energy producers – this could be a very long term trend, unless of course someone comes up with a car that runs on water. And by the way, I would like to wish that last bit to all of you (unless you’re a Russian oligarch).