Discussions around the Fed will continue to be a tightrope walk for the foreseeable future

Markets

Equity markets rallied last week primarily due to a decline in bond yields. The S&P 500 showed a robust performance, surging by 2.2%. Sectors like banks, materials, and consumer discretionary led the gains, with positive contributions seen across all sectors, and even small caps were getting swooped up. 

Yields have turned lower in recent weeks for a variety of reasons. But the primary catalyst was a string of soft US economic data highlighted by the October US CPI report that was well-behaved and ushered in Q2 2024 rate cut expectations. Indeed, a new soft landing bull case is building on the back of the Fed, which might decide to deliver a series of "insurance rate cuts" as early as Q1 2024

Meanwhile, oil prices have faced downward pressure due to global concerns about demand and increased supply. West Texas Intermediate (WTI) is nearly $20 below its peak in September, providing additional relief via income inflation.

Officials have alluded to the mechanical effect of receding inflation on the actual policy rate, making "insurance cuts" in 2024 probably inevitable.

The logic is clear-cut: The concept of "insurance cuts" to prevent passive tightening is seen as almost inevitable if core inflation continues to moderate. 

And there might be a misconception in some market circles regarding the bar for rate cuts. The conventional narrative suggests that a Fed still wary of past economic challenges would be hesitant to cut rates even in the face of softer data. However, with rates at 22-year highs and the Fed anticipating that monetary restraint will eventually slow demand, there might be a quicker inclination to cut rates as Fed policy is finally operating in a not-so-mysterious lag, as indicated by the latest run of softer US economic data.

In any event, discussions around the Fed will continue to be a tightrope walk for the foreseeable future. 

Over the past week, money has been pouring into stock Funds. The sentiment in the equity market has improved this month, influenced by a shift in tone within the bond market. A series of favourable and softer macro data in the United States has bolstered confidence among duration bulls and has strengthened dovish rate expectations.

Given that concerns in the equity market were closely tied to developments in the bond market, the relief in rates directly translated into a grandiloquent rally off the October 27 lows.

The latest haul, amounting to nearly $26 billion, is the second-largest financial influx of 2023.

This recent development is likely aligned with the contemporary playbook observed by stock operators. As fixed income experiences a rally, stocks tend to follow suit. However, the current scenario is distinct as it coincides with significant bets on a potential shift in the Federal Reserve's policy outlook towards a more accommodative stance.

The recent market " buy all" dynamics, including a mammoth rally for small-caps and a surge in inflows to high-yield credit, have led to varying interpretations. While the rally in big tech amid receding bond yields is seen as reasonable given the mega-caps quality characteristics that can provide a shield in an economic downturn, the significant rally in small-caps and a surge in high-yield credit inflows are viewed by some as an expression of irrational faith in an "immaculate" resolution to the most challenging macroeconomic environment in a generation.

The recent "small cap" price action is more complex than a straightforward shift where investors suddenly embrace assets they had previously disregarded. However, rate-cut fever has a funny way of creating a rally-wagon narrative.

Much of small-cap buy-in reflects a short covering unwind of less profitable companies and those with steep maturity walls, creating a massive top-side grab for cover reflecting a world where institutional investors had limited net exposure due to big short books and a lack of sufficient gross.

Oil markets: The ball is in Saudi Arabia's court

Crude oil has faced renewed downward pressure, with WTI recently dropping to approximately US$75/bbl, a significant decline from its late-September peak of $95. Since October 7, concerns about a weakening global economy and the consequent slowdown in global oil consumption have driven this downward trend. While these concerns are valid, the larger drag on oil prices appears to be rising production.

Despite economic fears, global oil demand has proven resilient. The International Energy Agency (IEA) estimates an average demand of 102 mb/d for the entirety of 2023, up from its original projection of 101.6 mb/d at the beginning of the year and 99.6 mb/d in 2022. The IEA forecasts a more modest increase of 930 kb/d in 2024, reflecting an expectation of cooling global growth rather than a recession. OPEC, however, projects a substantial increase of 2.3 mb/d in 2024.

One factor supporting the IEA's more conservative projection is the potential slowdown in Chinese demand, which has surged this year due to the petrochemical industry. China is expected to contribute 1.8 mb/d to the total 2.4 mb/d increase in oil consumption this year.

On the supply side, global oil supply is estimated to rise by 1.7 mb/d, reaching a record high of 101.8 mb/d in 2023, despite OPEC+ production cutbacks. The United States, Brazil, and Guyana have significantly contributed to offsetting OPEC's cuts. The importance of OPEC+ production cuts becomes evident when considering the potential impact on crude oil prices if these cuts were not in place.

Looking forward, OPEC+ may need to implement additional cuts if non-OPEC+ supply continues to grow at its current pace. The upcoming November 26 meeting may not be straightforward, as Saudi Arabia, which is shouldering a significant production cut (25% of total capacity), may be growing weary of this burden. Meanwhile, certain cartel members are producing above their quotas.

Despite concerns earlier in 2022 about peak oil supply, the situation has evolved, with cartel members no longer struggling to meet production quotas and U.S. production, currently at 13.2 mb/d, surpassing pre-pandemic highs. The dynamics in the oil market highlight the delicate balance between supply and demand, with geopolitical and economic factors playing crucial roles in shaping future outcomes.

The responsibility to support prices is once again in OPEC+'s hands, particularly in Saudi Arabia's court. Despite Riyadh's reluctance, it is expected to bear the brunt of the cartel's production cuts. However, the decision to implement further cuts is not guaranteed, given the escalating tensions within the cartel and the rising geopolitical pressures, such as strained Saudi-U.S. relations. These factors point to increased volatility ahead for the oil market.