A week ago we reported that the rise in oil and gas prices caused by the conflict in Ukraine had increased the threat of worst stagflationary shock in reaching Europe since the 1970s. Europe is at high risk of sinking into a deep recession if Russia makes good on its threat to stop gas supplies. The United States appears to be on safer ground thanks to its much lower reliance on Russian energy products. After all, only 1% of the oil consumed in the country comes from Russia.
But that alone shouldn’t lull the world’s largest economy into a false sense of security.
With markets plagued by bearish economic signals, a cross-section of experts has been warning that the US economy could be hurtling towards a recession. Soaring energy and commodity prices, hyperinflation, a rapidly flattening yield curve and a slowing economy are signs that all is not well.
But Wall Street is now more concerned about a more short-lived but potent red flag: the negative correlation between oil stocks and the broader US stock market.
The correlation between S&P 500 Energy Index and the widest S&P 500 it has turned negative for the first time since 2001, thanks to a combination of rising oil prices and a selloff in the tech sector. The S&P 500 has returned -6% year to date, a far cry from the energy index, which is up 39% year to date. the Information Technology Index it is doing even worse, down 10% over the time period.
Analysts are now warning that such large divergences have historically preceded recessions.
Commodity Context Founder Rory Johnson has told Bloomberg that the last time the correlation between oil and gas stocks and the broader market was this great, the dot-com bubble burst.
“With oil prices as high as they have been, that will be a positive for energy stocks and a negative for the rest of the economy overall.” Johnston said.
According to Johnston, the divergence between energy and the broader market has been increasing since the beginning of the year, but “went into overdrive” since Russia invaded Ukraine in late February and sent oil prices above $100 a barrel, while introducing new geopolitical risk to the stock market.
Related: US energy tycoons see 10% net worth rise since start of Ukraine war
Like most long-term trends, the normally positive correlation between the energy sector and the broader market is likely to return to the mean. However, analysts warn that there will be no soft landing.
“For energy prices to fall significantly, we could be talking about a recession-type situation, in which case the S&P 500 would also likely fall significantly, and thus the correlation would re-enter positive territory.”Stifel Nicolaus analyst James Hodgins told Bloomberg.
Great Inflation 2.0?
Since the correlation between energy stocks and the rest of the stock market tends to stay positive in both good and bad economic cycles, it is not a very reliable indicator of the state of the economy.
Wall Street has devised other yardsticks, and the yield curve is a favorite.
The yield curve is the difference (or “spread”) between short-term and long-term government bond yields. An inverted yield curve, where short-term bonds outperform long-term bonds, has correctly forecast every recession since 1955, with only one false signal in nearly 70 years.
And a flashing red warning sign has appeared: On Wednesday, the spread between Two-year and 10-year yields on US government bonds. dropped to just 0.2%.
Even assuming the yield curve is throwing another false red flag, meaning we’re not on the verge of a recession, the alternative isn’t very encouraging either. Because the one time an inverted yield curve didn’t lead to a recession, it attracted something just as bad: the “great inflation”, which lasted from the mid-1960s to the early 1980s.
The US inflation level has now reached 7.9%, a level last seen in 1982, when the last Great Inflation ended. But it could get even worse: traders are now setting prices at a US inflation rate heads for 8.6% through March and Aprill before Federal Reserve officials have a chance to offer a possible 50 basis point interest rate hike in May.
The Fed last week made its first rate hike in four yearsraising the fed funds rate by 25 basis points.
“Unfortunately, this might have been the time when the market and society needed a show of surprise and amazement that the Fed is still very focused on keeping inflation low. Raising rates by 25 basis points, without quantitative adjustment, has almost added fuel to the fire. Main Street is saying, ‘We can raise prices however we want, regardless of the competition.’ So far, it’s correct,Gang Hu, a TIPS trader with New York hedge fund WinShore Capital Partners, told MarketWatch.
That said, several critical recession signals remain green.
First, industrial production, a key indicator of economic strength, increased 0.5% in February to a level that is 103.6% above the 2017 average and 7.5% above the which was at this time last year.
the US Purchasing Managers’ Index (PMI), which tracks sentiment among buyers who work for manufacturing and construction companies, came in at 57.3 last month, more than 6% higher than the US average over the past decade.
Meanwhile, the US economic policy uncertainty indexwhich measures concerns related to politics, also fell to 139 in February, down from more than 200 in December 2021, indicating that fears around a political mishap from the Federal Reserve or the Biden administration are rising. are fading fast.
Perhaps the outcome of the Ukraine crisis will be the last straw that pushes the US economy into a full-blown recession or back into recovery mode.
By Alex Kimani for Oilprice.com
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