- The growing divergence between energy stocks and the broader market is bad news for the global economy.
- The divergence between energy and the broader market went into overdrive when Russia invaded Ukraine.
- Traders are now pricing in a U.S. inflation rate heading for 8.6% through March and April.
A week ago, we reported that the rise in oil and gas prices triggered by the Ukraine conflict had raised the threat of the worst stagflationary shock to hit Europe since the 1970s. Europe is at high risk of plunging into a deep recession if Russia follows through with its threat to halt gas supplies. The U.S. appears to be on safer ground thanks to its much lower reliance on Russian energy commodities. After all, only 1% of the country’s consumed oil comes from Russia.
But that alone should not lull the world’s largest economy into a false sense of security.
With the markets rife with bearish economic signals, a cross-section of experts has been warning that the U.S. economy could be hurtling towards a recession. Sky-high energy and commodity prices, hyperinflation, a rapidly flattening yield curve and a slowing economy are signals that all is not well.
But Wall Street is now more concerned with a more ephemeral but potent red flag: negative correlation between oil stocks and the broader U.S. stock market.
The correlation between the S&P 500 Energy Index and the broader S&P 500 has gone negative for the first time since 2001, thanks to a combination of rising oil prices and a selloff in the tech sector. The S&P 500 has returned -6% in the year-to-date, a far cry from the energy index, up 39% YTD. The Information Technology Index is faring even worse, down 10% over the time frame.
Analysts are now warning that such large divergences have historically preceded recessions.
Commodity Context founder Rory Johnston has told Bloomberg that the last time correlation between oil and gas stocks and the broader market was this big, the Dotcom bubble burst.
“With oil prices going as high as they have, that’s going to be positive for energy stocks and negative for the rest of the overall economy,” Johnston has said.
According to Johnston, the divergence between energy and the broader market has been growing since the beginning of the year, but “went into overdrive” since Russia invaded Ukraine at the end of February and sent oil prices above $100 a barrel while introducing new geopolitical risk into the stock market.
Like most long-term trends, the normally positive correlation between the energy sector and the broader market is likely to revert to the mean. However, analysts are warning that there won’t be a soft landing.
“For energy prices to fall significantly, we could be talking about a recessionary type situation in which case the S&P 500 would also likely fall significantly and therefore the correlation would come into positive territory again,”Stifel Nicolaus analyst James Hodgins has told Bloomberg.
Great Inflation 2.0?
Given that the correlation between energy stocks and the rest of the stock market tends to stay positive in both good and poor economic cycles, it’s not a very reliable gauge of the state of the economy.
Wall Street has come up with other yardsticks–and the yield curve is one of the favorites.
The yield curve is the difference (or “spread”) between yields on short-term and long-term government bonds. An inverted yield curve, where short-term bonds yield more than long-term bonds, has correctly predicted every recession since 1955, with only one false signal in nearly 70 years.
And a blinking-red warning sign has appeared: On Wednesday, the spread between two and 10-year yields on U.S. government bonds narrowed to just 0.2%.
Even assuming the yield curve is giving another false red flag, meaning we are not on the brink of a recession, the alternative is not very encouraging, either. Because the only time an inverted yield curve did not lead to a recession, it beckoned something just as bad: the “Great Inflation,” which lasted all the way from the mid-1960s into the early 1980s.
U.S. inflation level has now hit 7.9%, a level last seen in 1982–around the time the last Great Inflation ended. But it could get worse still: traders are now pricing in a U.S. inflation rate heading for 8.6% through March and April before Federal Reserve officials even get a chance to deliver a possible 50 basis point interest rate hike in May.
The Fed last week delivered its first rate hike in four years, raising the fed-funds rate by 25 basis points.
“Unfortunately, this might have been the time that the market and society needed a shock-and-awe showing the Fed is still very focused on holding inflation down. To hike rates by 25 basis points, with no quantitative tightening, has almost put fuel on the fire. Main Street is saying, `We can raise prices however we want to, without regard to competition.’ So far, it is right,”Gang Hu, a TIPS trader with New York hedge fund WinShore Capital Partners, has told MarketWatch.
That said, several critical recession signals remain in the green.
First off, industrial production, a key indicator of economic strength, rose 0.5% in February to a level that is 103.6% above the 2017 average and 7.5% above what it was at this time last year.
The US purchasing managers’ index (PMI), which tracks sentiment among buyers who work for manufacturing and construction firms, came in at 57.3 last month, more than 6% higher than the U.S. average over the last decade.
Meanwhile, the U.S. economic policy uncertainty index, which measures policy-related worries, also fell to 139 in February, down from over 200 in December 2021, indicating fears surrounding a policy mishap from the Federal Reserve or Biden administration are rapidly fading.
Maybe the outcome of the Ukraine crisis will be the final straw that pushes the U.S. economy into a full-blown recession or pulls it back into recovery mode.
By Alex Kimani for Oilprice.com