Not Yet

FRI 08 JUL 2022

There is little doubt that the prevailing bias has shifted from inflation and interest rate fear to growth risk. In recent weeks the deterioration in consensus beliefs on growth has also spilled over into commodity prices ( -10% on the broad index, -15% in spot crude and -30% in spot copper from peak). The declines in price, specifically on crude and refining margins, are probably consistent with a 1.1% downward revision to global growth in the second half of the year according to Goldman Sachs. The big picture question is whether this is an emotional overreaction or warranted given the tightening in broad financial conditions?

From our perch, the magnitude and speed of the tightening in financial conditions combined with the deterioration in new orders and a range of confidence surveys suggests that the odds of a material contraction in growth and profits has probably increased in a meaningful way. As we noted earlier this week, we are not uncertain on the risk of recession.

However, in the very near term current conditions in the US labour market remain very strong. The time series below highlights the Kansas Fed’s labour market conditions index at peak levels (dark blue). Of course, previous cyclical inflection points started from peak conditions and the material tightening in financial conditions (light blue line inverted scale) suggests that the labour market will likely start to deteriorate over the coming months.

However, the key for short term interest rate markets is that the Fed will still view the current conditions as robust and will therefore probably still deliver +75 basis points in July and +50 basis points in September. That will likely take policy rates and financial conditions into restrictive territory. Stated differently, while the odds of a recession have increased, the key for markets is - not yet.

For the commodity markets, a global recession typically leads to a sharp contraction in demand. However, as we noted this week with respect to copper and oil, the physical markets remain fairly tight. Indeed, for oil, the crack spread (at $42) or the difference between crude and gasoline is probably consistent with spot around $150 per barrel (chart 2).

The other big picture point to note is that China’s credit impulse or the rate of change in credit growth has started accelerate and is a reliable leading indicator of demand for industrial metals and commodities more broadly (chart 3). China is still the largest source of final demand for most commodities. The authorities have also announced further infrastructure stimulus which is allocated via the state banking system and hence the acceleration in the credit impulse. While we are sympathetic to the shift in consensus beliefs to recession risk, the recent weakness in commodities and mining equities might be a short term emotional over reaction. The sector also has extremely high free cash flow and a large margin of safety.