Equities and the Economy
Good morning and happy National Black Cow Day (aka Root Beer Float). U.S. equities closed virtually unchanged from Monday yesterday in a choppy session with the main indexes giving up earlier modest gains. The Dow closed down 3 points at 17,764, the S&P 500 added 1 to 2,080 and the Nasdaq finished off 8 at 5,014. The support trend line I mentioned in yesterday’s report has held, so far. I know most of you follow the equities markets and know, at least, whether the major indexes were up or down on a particular day. But I’ll bet you’re not following the bond market. And that’s where all the action has been happening as of late. Remember now, that as big as you may think the equities markets are, they are dwarfed by the capital in the bond market. The reason you need to watch the bond market is that as bond yields move, money moves into and out of bonds and into other assets, mostly equities. Capital is liquid and moves to where the perceived highest yield is. Think of it as a drop of mercury on a plate of glass and easily moving around the glass as yields change. Lately bond yields have been rising. It began last April when German bonds, which is the European equivalent of the U.S. Treasury, got routed sending yields much higher. Yesterday and today bonds have been getting whacked with the 10 year German bond hitting 1% for the first time since September and the U.S. 10 year Treasury yield hitting an 8 month high yesterday with it higher today. So you may be thinking “I have none to few bonds in my portfolio so what do I care?” Well you should. As bond yields rise it takes money away from the equities market. And remember, a bull market needs to fed. For a market to fall you don’t necessarily need selling to come in. You just need the buying to stop. And then the selling comes in. Money managers have a term for when there is a major shift in where money goes, i.e., to the equity market or the bond market or vice versa. It’s called a “rotation.” So what’s driving this change in bond yields? Expectations of inflation, not just here in the U.S. but also in Europe. Yes, things in Europe are getting better, with the exception of Greece where the citizens are still going through the shock that they have to work to earn a living. Central banks around the world have been flooding the markets with cheap money, i.e., QE, and how did they do that? By buying bonds and driving down bond yields making equities more attractive on a risk adjusted basis. Now they’re taking the punch bowl away, particularly in the U.S., with the Fed soon to raise interest rates which creates less demand for bonds which raises bond yields.
The only material economic news yesterday here in North America was the National Federation of Independent Business Report. This is important because and is a good index to follow to see what’s going on in the small business sector, which is where most of the jobs in the U.S. are created. The report was good with the index rising 1.4 points to 98.3 with optimism in the sector is rising. More news supporting an interest rate rise.
This morning we’re off to a great start with the Dow up 164 points getting help from European equities which are all trading nicely in the green.
WTI and Brent made big moves up yesterday with the former adding an even 2 bucks (3.4%) closing at $60.14 and the latter up $2.19 (3.5%) settling at $64.88. The EIA released two important statistics yesterday. The first was that May oil production averaged 9.6 million bpd, the highest level since 1972! The second was that it revised its forecast for domestic oil production saying it now expected a drop of 160,000 bpd in U.S. oil output next year. The previous forecast showed a rise in production. So you may be thinking “So why did oil prices rise? The first data point was bearish and the second bullish. Shouldn’t they offset?” Because traders trade the future, not the present. They trade oil “futures” and the future is more bullish. When discussing the energy market with my clients one of the discussions I have with them is “What is the propensity for prices to go higher from where they are today or lower?” Adding fuel to the price fire is the fact that U.S. dollar has been getting obliterated lately vs. the euro (and the yen).
This morning WTI is tacking on another $1.37. This time the driver is API’s report released yesterday evening showing crude oil inventories fell last week by 6.7 million barrels. Analysts were expecting only a 1.72 million barrel drop.
Natural gas prices continue to increase primarily driven by the cash market which itself is being driven by the above normal temperatures currently being seen in the Midwest and MidAtlantic. Additionally, last week the market got very oversold on the heels of the EIA storage report which showed a record setting injection. It’s just too early in the summer to give up on natty. The July contract closed up 14.1¢ (5.2%) at $2.846 and has risen 9.6% in just the last two days. On any day but Thursday it’s all about the weather and the weather forecast is currently supportive of prices. Not raging bull supportive, but supportive. That being said, $2.8580 (which is where July is this morning), is still really cheap gas. Memories are short and it was about this time in 2008 when natty was trading over $13 per MMBtu! Once again, thank you horizontal drilling and hydrofracking.
Hat’s off to us! According to BP the U.S. has surpassed Russia as the world’s’ largest oil and natural gas producer. U.S. annual oil production rose to an all-time high last year with natural gas output also rising putting America ahead of Russia as the biggest producer of hydrocarbons combined. This seismic shift in the global energy landscape is the result of our ability to now economically extract hydrocarbons from shale. The U.S. boom in oil and gas production has started to change the economy profoundly. Cheap fuel has seen manufacturing return to the U.S. with our country producing about 90% of the energy it consumed last year. Last year imports equaled 1% of GDP while in 2007 imports accounted for about half of the current account deficit of 5% of GDP. The increase in oil production last year helped us overtake Saudi Arabia as a crude producer and was the first time a country has ever raised production by at least 1 million bpd for three consecutive years. Booyah! Have a nice day.