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Blind Leading the Blind

In August we noted that a key characteristic of 2023 has been swings in the prevailing bias on major macro trends that have caught consensus positioning and beliefs offside. At the start of 2023, most investors were positioned for recession in the first half only to be hit by underlying macro resilience. The prevailing bias then positioned for “higher-for-longer” only to be taken out to the woodshed by the US regional banking crisis. Then the consensus positioned for a credit collapse led recession and got caught offside with liquidity, fiscal support, and resilient growth again. From our perch, investors are positioned for “higher-for-longer” again just at the point where the lagged impact from prior policy tightening is starting to impact macro conditions.

A contributing factor to the recent consensus belief in “higher-for-longer” has been the sharp rally in spot oil prices. Of course, there have been both supply and demand driven factors driving energy prices higher. While oil is a “relative price” – producers win, and consumers lose with higher prices – rising energy prices tend to coincide with an increase in headline consumer price expectations. They have also probably been a cyclical factor that has contributed to the renewed rise in Treasury yields and tighter financial conditions.

Historically, oil has often rallied late in the past few cycles just as the macro cycle deteriorated. Arguably, the surge in energy prices in the first half of 2008, reflexive rise in market interest rates and tighter financial conditions may have been the factor (nail in the coffin) that tipped the global economy into recession in that episode. Note the sharp divergence between ISM new orders (as a proxy for growth) and oil in 2008 (chart 1). Also recall the ECB rate hike in July of that year 3 months prior to the collapse of Lehman.

A factor that has complicated the outlook for energy in the current episode is on the supply side. Resources are depleting fast because the easier and cheaper to extract have already been extracted. At the same time, the global population is still growing and therefore energy consumption is still expanding at a similar trend pace to recent history. In that context, starving fossil fuel producers of capital might not be a very wise decision. The conflict in Eastern Europe and tension with Iran has also amplified these pre-existing trends. In the shorter term, the cyclical outlook for demand might remain weak if there is a global recession.

Over the past 20 years, governments’ have spent around $5 trillion on “green energy.” While that has reduced the fossil fuel share of energy from 86% to 84%, world oil consumption has increased from around 77 million barrels per day to around 100 million barrels per day. Consensus estimates suggest oil consumption will continue to increase to around 107 million barrels per day by 2030. Currently, public listed companies contribute around 50% of global supply, but if future capital spending is constrained by the ‘Net Zero’ target and reduced supply from Russia, non-public companies (primarily from OPEC) will likely be required to increase supply. The bottom line is oil prices might increase rather than decrease because of the climate pressure on public oil companies.

From a cyclical perspective, just as investors positioned for “higher-for longer” the recent macro news flow has started to confirm the impact of the tightening cycle that started in 2022. However, as we noted in August, the deterioration in the macro news flow is only positive if the economy “soft lands” – that is the prevailing bias among fund managers according to the Bank of America survey (74% odds in September). It is also reflected in consensus earnings revisions which have trended higher again recently. Historically the odds of a soft landing are 2 in 12.

The big picture risk is that the macro news flow continues to deteriorate leading to a growth scare, recession anxiety and a deeper correction in equities over the next few weeks. Counterintuitively, the rally in energy prices might not be a signal of macro strength but a nail in the coffin of the macro cycle that is already deteriorating from the lagged impact of policy tightening last year. From our perch, and in contrast to “the famous investment bank” odds of a hard landing have increased, not decreased. We remain light and tight. The good news is that considerably more downside is priced in Asia and EM. The case for being long the long end of the Treasury curve has also increased.


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