Did someone ask for a summary of all the themes that dominated the last 4 weeks in financial markets and were the core topics of the Week at Close column since its beginning? Probably no, but I am going to give it to you. Not because there is nothing else relevant to talk about, but because the most dominant event of the week is related to all the subjects I have been discussing in the last month or so. All of them: monetary policy to curb inflation (W@C 1), the banking turmoil (W@C 2 and 3), and China’s modest growth (W@C 4). Welcome to the W@C 5.
The week started in full force, with a pre-market-open surprise reported during the weekend: OPEC+ announced a cut on oil production by a million barrels a day in response to a lack of demand. The statement came ahead of their Monday’s virtual meeting: the JMMC. Crude oil rallied as much as 8%, even though it had been one of the worst-performing assets year-to-date.
While unexpected, this is far from unprecedented. The countries in the group are highly dependent on their oil exports to have an important fiscal buffer to reinvest in their economies. Saudi Arabia led the cartel in this decision: it pledged its own reduction of 500 thousand barrels a day. The reason is simple: they want higher oil prices, hence higher government revenues. Nevertheless, there is an upper limit on this desire – let’s call it a breakeven. As soon as the breakeven is surpassed, the increase in prices dampens demand, slowing down the rest of the world’s economies, and driving demand down even further. The final outcome is predictable: prices will end up falling.
The question that then remains regards the level of this breakeven. We don’t know. It’s unobservable – and that’s why there are two arguments, related to monetary policy implications, coming out of this event: one inflationary, and the other disinflationary.
On one side, and probably more intuitively, the increase in oil prices has as a direct consequence added pressure to the overall increase in prices. Actually, and especially in Europe, the surge in inflation coming from the end of 2021 was and still is very deeply affected by the increase in energy prices.
On the other, however, people put in the equation not only the fact that inflation is already in a downward trend and consumers are developing an inflation tolerance, but also the growth variable that is undermined by this increase. The reasoning goes as follows: higher oil prices have asymmetrical effects and have a higher impact on low- and middle-income households, which are then forced to cut expenditures in other elements of their consumption basket. This rationalization will play an overall price-decreasing role.
While the latter may be more accurate, we need to be careful in rushing to strong conclusions, for one main reason: inflation expectations. People don’t feel straight away the potential decrease in economic growth, but they surely feel immediately the increase in oil prices. The problem is when they feel it and start wondering about the future. If things are dark now, once again, should I rationally expect things to get better very soon? Probably not.
It is like expecting Bocconi professors to suddenly start making easy exams, when not even a month ago we were hit by once-again-destructive mid-terms. It gets to a point where we become so used to getting hit so hard that there is no way we start expecting a reversion in the trend. This is the nightmare of a central banker: not to have Bocconi students have good grades, but to have people expecting prices to remain sticky or even increase further.
Financial markets actually reacted to the news as being a potential inflation accelerator. The market opened on Monday with a sell-off in Treasury bonds, driving yields higher, reflecting the expectation of a stronger need for monetary tightening to combat the added pressure in the already high level of prices.
More remarkably, however, market participants didn’t rethink their expectations beyond the very-next meetings, despite the narrative of higher-for-longer oil. The priced interest-rate-cut cycle remained more-or-less intact. As of Friday, a full percentage point of interest rate decreases is still expected to occur until January 2024.
It is worth pointing out that the reshaping didn’t take place for one possible reason: even though this OPEC+ story may somewhat counterbalance the effects of the banking turmoil that stormed the market a couple of weeks ago, these two events are more related than what is apparent.
To understand why, let’s go back to the special year 2008. Back then, as a consequence of the absolute financial drama, oil prices plummeted massively. From a high of around $130, oil fell to $39.09 in less than a year – a SEVENTY-percent decline. Imagine the impact on the oil-exporting countries.
It is then completely understandable to realize that these countries started shaking as soon as they started seeing the 23’ banking crisis. What if it all happened again? Has some form of PTSD played a role in this announcement? I am not going to say no – especially given the fact that one of the leaders of the group, Saudi Arabia, had a BIG exposure to Credit Suisse. To be honest, it was an action from a Saudi (the chair of the National Bank) that started the final fallout of the bank.
So, how far can we go? At what price level may we end up? As stated before, there is a point, the breakeven, which not even the OPEC+ countries want to reach. We are currently at around $85 a barrel. Can we reach $100? Well, it won’t be that easy – not only because of the psychological barrier that is broken but mainly because of the weak support in the demand side from one important side of the world’s economy: emerging markets (EM) and China.
As you may have read in last week’s article, the slowdown of the Chinese economy over the last 3 years is certainly not yet going to be healed through strong growth. The demand coming out of the country – projected at 5% despite the low base from where it came in 2022 – will not be enough to add more impactful pressures to commodity prices.