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Capital 19 Catch-Up

Weekly Index Movement

S&P500+6.5%
Nasdaq+7.5%
Aussie All Ords+1.5%

US Stocks put in a very nice bounce-back from oversold conditions last week as oil and interest rates fell.

The good news for equity investors is markets are starting to ratchet down how high they think rates will go. Despite repeated Fed speakers calling for another 75bps rise in July the two-year yield has started to fall. The 10yr yield has fallen from highs near 3.5% to around 3.1% on Friday.

This is constructive for equity prices because it reduces upside risk for rates overall.

With such a big move up in stocks last week and rates beginning to fall, it does beg the question of whether we have seen the bottom for stock prices in 2022?

The first half of 2022 so far has been the worst half-year return for stocks since 1970 and so far Q2 of 2022 has been eerily similar to Q1 of 2022.

Both quarters started out with fleeting gains that quickly succumbed to selling pressure with little relief throughout the quarter. The only relief in Q1 came in the second half of March when the S&P500 rallied 11% off its lows in eleven trading days.

This time around, the late quarter rally took longer to materialise, but in the five trading days since the close on June 16th, the S&P500 has rallied 6% with 4 trading sessions left in the quarter.

In order for investors to have the confidence that this current rally has more behind it, they’re going to want to see more than just a late quarter rally but also some follow-through into Q3.

Last week we highlighted the change in Fed speak to now target headline inflation. In testimony to Congress this week, Chair Powell admitted that he “would not think so, no” when asked if higher rates would bring down gas prices and characterised food price response to tightening similarly.

On that point, we agree, but it makes Powell’s decision last week to highlight headline inflation as deeply confusing messaging. Historically, a coordinated global tightening regime like the one that central banks have launched in 2022 in response to high commodity prices has not worked out well.

Commodity price surges in 1972 (oil embargo), the late 1970s (peak structural inflation), and the mid-2000s all led to extremely weak economic outcomes including multiple early-1980s recessions and the global financial crisis.

Powell is wrong when he says that rate hikes won’t bring down gas prices; the Federal Reserve is absolutely capable of tightening its way into a lower price at the pump. The problem is that the only way to do so is to tighten until oil demand falls thanks to a global recession, and that outcome is looking more likely by the day.

Equity bear markets are a fairly reliable indicator of future recession. In general, bear markets and recessions are closely tied together. Since World War 2, only two periods have seen bear markets without a recession starting in short order, in 1966 and 1987. In all other instances, a recession was either already underway or would start during the course of the bear market.

After the invasion of Ukraine earlier this year, strong demand was met by a huge supply shock spanning metals, energy, and agricultural commodities. But over the last couple of weeks, prices have reversed in a dramatic fashion with 20%+ drops across grains, natural gas, and metals.

Of the major commodity groups in the Bloomberg Commodity Index, all but energy have closed with a lower spot price than where things stood on the eve of the invasion of Ukraine.

Supply is still constrained, to be sure, with US oil production only rising at a modest pace and refineries unable to keep up with global demand for refined products.

On the grains side of the equation, supply is flowing out of the Black Sea region at a better than expected pace while concerns over US crop health and therefore yields are easing.

Industrial metals are also seeing falls in specific demand from places like China, where the economy remains weak despite policy easing.

But the biggest spectre of all is the global demand outlook: markets are rapidly reevaluating how long demand can be sustained amidst epic monetary tightening and a huge tightening of financial conditions.

Overall, commodities are on a similar path to rates, with both getting pushed lower by the prospects of policy errors around the world.

This is why the Australian stock market has been weak of late and why it did not see the bounce as the US did last week.

This theme is likely to continue as long as the chances of recession build.

It is just like the old saying goes

“When the US sneezes, Australia catches a cold”

The prospects for Australian stocks do not look great until these recession fears abate.

Except for Energy.

By now you will know how much we like the Energy Sector.

Energy prices have fallen as a result of the recent decline in all commodity prices which, as we just argued, is mostly about markets discounting weak demand thanks to policy errors by central banks.

Lower prices have not addressed the driver of the recent price surge, though: the supply side. Regular, unleaded gasoline topped $5 nationally in the US and has since fallen to the high $4.90s area, still an extreme level historically. The driver of those prices is two-fold: high crude prices (which remain well over $100/ barrel despite a tumble from above $120) and high spreads between crude and refined products.

Surging prices for crude have helped Energy names deleverage quite dramatically; debt for Energy names is near the lowest levels since 2014. In addition to cutting debt loads, high oil prices are letting management buy back shares and return capital via dividends. All of that cashflow is not being plunged back into capex, which basically hasn’t recovered at all from its decline following the COVID shock despite strong global crude demand.

This week, energy moved in the opposite direction of the broader market, just as it had last week. From the high on June 8th through last Friday’s close, though, the S&P 500 Energy sector fell over 20%.

This is your opportunity to buy the dip.

The only thing that can reduce oil prices is a global recession.

The last US refinery was built in the 1970s. They will not be building any more.

The oil industry has been told for a decade its services are no longer required. Building new refineries or developing existing resources takes many years of work and very large investments.

Typically it might take a decade or two to recover those investments once the product comes on line and because the world is telling oil we don’t want to use it after 2030, oil companies will not spend that capex to build.

With no additional supply coming online but the demand side of the equation remaining steady, oil prices will not be coming down significantly.

In fact, energy security is becoming important for countries. China has cut its refined product export quotas as Beijing attempts to ensure domestic supply of fuels to generate GDP growth. China slashed gasoline, gasoil, and jet fuel exports by 51.7% year on year

Lastly for today, we thought we would share this with you. Prior to this week the S&P500 had fallen at least 5% in the last two weeks. This has only happened seven other times in the post WW2 period. The red dots on this graph highlight when that was.

The good news is, in every other instance, the six and twelve month returns following these events have been positive.

Albert Einstein once said, “In the midst of every crisis, lies great opportunity,” and hopefully with the benefit of hindsight, we’ll be able to say that at this time next year.

Warning

Stock values can go down as well as up. It is possible to lose 100% of your investment in a stock. Any advice given by Capital 19 is general advice only and does not take your personal circumstances into account.

Disclaimer: Capital 19 Pty Ltd ABN 17 124 264 366 AFSL 441891 (‘Capital 19’) believes the information contained is reliable, however, no warranty is given as to its accuracy and persons relying on this information do so at their own risk. This communication is for general information only and was prepared for multiple distributions and does not take account of the specific investment objectives of individual recipients and it may not be appropriate in all circumstances. Persons relying on this information should do so considering their specific investment objectives and financial situations. Any person considering action based on this communication must seek individual advice relevant to their circumstances and investment objectives. Subject to any liability which cannot be excluded under the relevant laws. Any opinions or forecasts reflect the judgment and assumptions of Capital 19 and its representatives based on information at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future. The investment manager certifies that all the views expressed in this document accurately reflect their views about the companies and securities referred to in this document and that their remuneration is not directly or indirectly related to the views. Capital 19, its directors, representatives, employees or related parties may have an interest in any of the companies and securities in this document and may earn revenue from the sale or purchase of any financial product referred to in this document or any advice. Past performance is not a reliable indicator of future performance. Unauthorised use, copying, distribution, replication, posting, transmitting, publication, display, or reproduction in whole or in part of the information contained in this document is prohibited without obtaining prior written permission from Capital 19.