Short Fear In The New Year

06 January 2025

In our big picture outlook for 2026 we argued that there were three upside risks to growth. First, we are only halfway through the AI capex super cycle and associated productivity boom. Second, financial conditions were very accommodative. Third, the US fiscal impulse remained supportive, and the US administration was motivated to “run the economy hot” into the mid-terms. In Asia, we argued that the supply-chain leveraged to the AI boom remained inexpensive or underappreciated. Domestic growth and real estate remained challenged in China. Finally, Vietnam is the most attractive growth opportunity in the region.

Tactically, the major indices consolidated in a range through November and December. Over the past two months markets have questioned sustainable returns on market leaders in the AI space with some rotation out of NVIDIA into Alphabet (Google) and into the leaders in Asia. From a macro standpoint, the key big picture question is whether US employment will contract or reaccelerate. As we noted last year, that is pivotal for the Fed’s reaction function and the outlook for consumption and final demand. If the US labour market contracts, a re-acceleration in consumer price inflation is unlikely. It would also allow the FOMC to cut policy rates below 3% (neutral) in 2026. A related question is how a post-Powell Fed will manage monetary policy this year.

In the medium term, and as we noted late last year, sovereign debt is likely to be a challenge for the United States and most other developed markets including Japan and China. Debt levels are already high; demographics will add to the spending. There will also be fewer taxpayers in the future. High real interest rates are also deteriorating debt servicing. America’s cycle adjusted deficit -7.7% of GDP is already at emergency levels before any potential rise in unemployment. Running the economy hot or maintaining a positive fiscal impulse will support growth in the near term. However, it also likely explains the ongoing strength in gold and precious metals (see our note on the “Great Fiat Debasement” last year). Tactically, the non-linear price action in precious metals was a warning sign and resilience in growth, short tern interest rate expectations (the competing asset for gold) and the US dollar might lead to some consolidation in the immediate term.

The other key development early in the new year has been the US military operation in Venezuela. Long term, this likely further undermines the global rules-based order. The action will likely accelerate reserve diversification away from the US dollar by China and others into gold. On the positive side, if the action leads to lower oil prices, that is likely positive for America and challenging for Russia. A weaker Russian economy would increase the probability that the conflict in Ukraine would end sooner and on more favourable terms. China is also the largest buyer of Venezuelan oil (accounts for ~5% of China’s total annual imports). It might also lead to regime change in Iran.

Venezuela famously holds one of the largest oil reserves in the world. According to Wood Mackenzie, there are ~241 billion barrels of crude oil that are deemed recoverable but not yet produced. However, Venezuelan production is much smaller at ~0.9 million barrels per day over the last year. That compares to ~12.1 million for the United States and 9.2 million barrels per day for Saudia Arabia and Russia. Under-investment and the impact of sanctions have hit Venezuelan production hard. Production peaked at ~3.5 million barrels per day in the late 1990s. In the short term, the International Energy Agency also forecasts a global surplus in production this year of 2-3 million barrels per day. The global market is well placed to absorb any temporary supply disruption caused by Venezuela or Iran. That likely explains the weakness in spot crude after the weekend.

An observation we made in 2022 was that there is a potential structural risk on the supply side for oil. Resources had been depleting because the easier and cheaper to extract had been extracted. At the same time, the global population was still growing and therefore energy consumption was still rising. Demand for energy has also been amplified by AI and data centres. In that context, fossil fuel producers had also been starved of capital in recent years by net-zero policies. The big picture point is that opening Venezuela’s reserves to new investment and increased production might be a positive development for the global economy. Of course, oil trading around $50 is challenging for the marginal producer. In that context, the energy sector is trading close to the record low relative to the S&P500 (chart 1) and at a 60% price to cash flow discount.

Chart 1

Source: Bloomberg

In conclusion, the major upside risks to growth remain in place: the AI capex super cycle, easy financial conditions, and supportive fiscal policy. We also view developments over the weekend through an optimistic lens, if there are conflict resolution, cheaper energy, and lower inflation. That might help central banks lower rates with a more favourable growth-inflation trade-off. The global energy sector is unloved and trading close to the record discount relative to the broad market. From our perch, that is interesting.

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