A week ago we reported that the spike in oil and gas prices triggered by the Ukraine conflict threatened Europe with the worst stagflation shock since the 1970s. Europe risks falling into a deep recession if Russia follows through on its threat to cut gas supplies. The US appears to be on safer ground thanks to its much lower dependence on Russian energy commodities. After all, only 1% of the country’s consumed oil comes from Russia.
But that alone shouldn’t give the world’s largest economy a false sense of security.
As markets abound with bearish economic signals, a cross section of experts have warned the US economy could be headed for recession. Soaring energy and commodity prices, hyperinflation, a rapidly flattening yield curve and a slowing economy are signs that all is not well.
But Wall Street is now more concerned with a shorter-lived but more potent red flag: a negative correlation between oil stocks and the broader US stock market.
The connection between the S&P 500 Energy Index and the wider S&P500 has turned negative for the first time since 2001 thanks to a combination of rising oil prices and a sell-off in the technology sector. The S&P 500 has returned -6% year-to-date, a far cry from the energy index, up 39% year-to-date. the Information Technology Index is even worse, down 10% over the period.
Analysts are now warning that such large divergences have historically preceded recessions.
bubble bursts
Commodity Context founder Rory Johnston told Bloomberg that the last time the correlation between oil and gas stocks and the broader market was this great was the dot-com bubble bursting.
“If oil prices go as high as they have, it will be positive for energy stocks and negative for the rest of the broader economy,” Johnston said.
According to Johnston, divergence between energy and the broader market has widened since the beginning of the year but has “gone into overdrive” since Russia invaded Ukraine in late February, pushing oil prices above $100 a barrel amid new geopolitical risks were introduced to the stock exchange.
Also Read: US Energy Tycoons See Net Worth Up 10% Since Ukraine War Started
Like most long-term trends, the normally positive correlation between the energy sector and the broader market is likely to mean revert. However, analysts warn that there will be no soft landing.
“If energy prices fall significantly, we could be talking about a recessionary situation, in which case the S&P 500 would likely also fall significantly and therefore the correlation would turn positive again,” said James Hodgins, analyst at Stifel Nicolaus. to Bloomberg.
Great Inflation 2.0?
Given that the correlation between energy stocks and the rest of the stock market tends to remain positive in both good and bad business cycles, this isn’t a very reliable gauge of the state of the economy.
Wall Street has come up with other benchmarks – and the yield curve is one of the favorites.
The yield curve is the difference (or “spread”) between short-term and long-term government bond yields. An inverted yield curve, in which short-term bonds yield more than long-term bonds, has correctly predicted every recession since 1955, with just one false signal in nearly 70 years.
And a flashing red warning sign has appeared: On Wednesday, the spread between 2-year and 10-year US Treasury yields narrowed to just 0.2%.
Even assuming that the yield curve is giving the wrong signal again, 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 didn’t lead to a recession, something just as bad happened: the “Great Inflation,” which lasted from the mid-1960s to the early 1980s.
The US inflation level has now reached 7.9%, a level last seen in 1982 – around the time the last major inflation ended. But things could get worse: traders are now pricing in a US inflation rate headed for 8.6% by March and April, before Federal Reserve officials even get a chance to unveil a possible 50 basis point rate hike in May.
The Fed last week made its first rate hike in four years, raising interest rates by 25 basis points.
“Unfortunately, this was perhaps when the market and society needed shock and awe to show that the Fed is still very focused on keeping inflation low. The 25 basis point rate hike without quantitative tightening almost added fuel to the fire. Main Street says, “We can raise prices any way we want, regardless of the competition.” So far, it’s right,” Gang Hu, a TIPS trader at New York hedge fund WinShore Capital Partners, told MarketWatch.
However, some critical recession signals remain in the green.
First of all, industrial production, a key indicator of economic strength, rose 0.5% in February to a level that is 103.6% higher than the 2017 average and 7.5% higher than a year earlier at the time.
The US Purchasing Managers’ Index (PMI), which tracks sentiment among shoppers who work for manufacturing and construction companies, came in at 57.3 last month, more than 6% higher than the US average over the past decade.
Meanwhile, the U.S. Economic Policy Uncertainty Index, which measures policy-related concerns, also fell to 139 in February from over 200 in December 2021, suggesting fears surrounding a policy mishap by the Federal Reserve or the Biden administration are quickly fading .
Perhaps the outcome of the Ukraine crisis will be the last drop that pushes the US economy into a full-blown recession or pulls it back into recovery mode.
By Alex Kimani for Oilprice.com
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