US economic data remains strong, but a range of financial indicators point to a sharp slowdown over the next year that will dampen oil consumption and lower prices.
The apparent contradiction between the real economy and financial markets has baffled some commentators, but is normal around a peak in the business cycle.
Economic data reflects current conditions while financial prices reflect how traders expect the economy to develop in the future.
By definition, every downturn starts from a peak in the business cycle when activity is strong. The rapid shift from strong and rising economic activity to contraction is what makes turning points difficult to predict.
In recent decades, the largest forecast errors have occurred around turning points, especially peaks (“Business Cycles: Theory, History, Indicators, and Forecasts”, Zarnowitz, 1992).
But financial markets are currently attributing a high probability to a significant slowdown in the cycle over the next 6 months, which could be qualified as a recession, notwithstanding the high level of economic activity and employment.
World trade volumes and industrial production remained at or very close to record levels in June, according to the Netherlands Bureau for Economic Policy Analysis (“World Trade Monitor”, CPB, August 25).
U.S. freight volumes hit record highs in June and manufacturing output was near its highest levels since before the financial crisis, according to data from the U.S. Bureau of Transportation Statistics and the Federal Reserve.
Manufacturing activity continued to expand through August, albeit more slowly than before, according to surveys by the Institute for Supply Management.
The ISM Composite Purchasing Managers’ Index remained at 52.8 in July and August, slightly above the 50-point threshold that separates expanding from contracting activity, and in the 50th percentile for all months since 1980.
But a wide range of financial indicators from the fixed income, equity and commodity markets, as well as individual stock prices of leading companies, all point to a significant downturn in the cycle over the next six months.
Futures prices imply that the US central bank is expected to raise interest rates over the next six months to 4.25-4.50% before April 2023, from 2.25-2.50% currently, shockingly borrowers and the economy.
The US Treasury yield curve between securities maturing in two years and ten years is more inverted than at any time since August 2000, when the dotcom bubble began to burst.
Financial conditions are tightening at some of the fastest rates in more than a decade, according to the Chicago Fed’s Financial Conditions Index, which is based on measures of risk, credit and leverage .
US stock indices have already fallen as investors anticipate a slowdown affecting demand and further discount future earnings.
After adjusting for inflation, the broad US S&P 500 equity index is down about 13-14% from the same time last year.
Individual stocks closely tied to the cycle, including heavy equipment maker Caterpillar and diversified maker 3M Corporation, fell sharply in line with a significant economic slowdown.
South Korea’s KOSPI-100 index, which tracks the global trade cycle due to its high exposure to exporting manufacturing companies, is also down more than 23% from the same point last year.
The expected slowdown in the economic cycle is evident in fuel markets, where the spread between European diesel futures and Brent crude for April 2023 deliveries has softened to $30 a barrel from over $40. dollars at the end of August.
The diesel calendar gap between December 2022 and December 2023 fell to a discount of $12 a barrel, from $26 at the end of August to $33 in June, implying that inventories should be higher than before.
Diesel fuel and other middle distillates are the workhorse of manufacturing and freight transportation and the most sensitive to changes in the business cycle.
Lower spreads are consistent with a regional and global slowdown that would allow distillate inventories to rebuild from their current, heavily depleted level.
Bond, stock and commodity prices reflect what should happen, not what will happen – and those expectations could change or turn out to be wrong.
But financial markets are attributing an unusually high probability to an impending recession right now, so expectations cannot be dismissed lightly.
In the event of a significant slowdown in the cycle, it would be more severe in Europe and China than in the United States.
Europe is more directly exposed to the fallout from energy prices, high inflation and the possible gas supply disruption resulting from Russia’s invasion of Ukraine.
China is grappling with a persistent cycle of city-level lockdowns imposed to stop the spread of the coronavirus as part of its epidemic control strategy.
But the fallout from Europe and China as well as a massive tightening of financial conditions in the country should induce a significant slowdown in the United States itself.
Slower growth in the Big Three economies will also affect major emerging economies, including India, Brazil, Saudi Arabia, Indonesia, Turkey, Mexico and Thailand.
If the expected slowdown materializes, energy consumption will grow much more slowly in 2023, easing some of the pressure on coal, gas, diesel and crude prices.
Source: Reuters (edited by Elaine Hardcastle)