Financial Sense Newshour spoke with Dave Nicoski of Vermillion Research and with Ryan Sweet of Moody’s Analytics to get their takes on what 2020 has in store. In the Big Picture, Jim Puplava and Chris Preitauer look at the battle in the energy markets.
See Energy vs. the Markets for the full podcast.
Emerging Markets Waking Up
The Fed’s easing policy has helped revive the once lackluster emerging markets, Nicoski explained. He sees bottoms in several of these markets, but the process takes time. Rates around the world have been much lower compared to the U.S., which is one of the reasons the Fed has acted to lower rates. This, in turn, is helping emerging markets power higher.
Conversely, the dollar has remained relatively strong, though “we haven’t really been able to propel out to new highs in the U.S. dollar for several months,” Nicoski said. “I think that’s a signal. If the U.S. dollar does violate the uptrend—which we’re on the cusp of right now—we’re going to push those emerging markets much further.”
Inflections Signal Strength
Nicoski’s work focuses on measuring the health of the global economy and equity markets. He believes there are several factors that are supportive of strength going into next year. He’s also looking at inflection points that are emerging in key markets and said that he’s seen considerable weakness in commodities, energy and basic materials in the past year.
A reversal in small caps could push markets higher. Historically, small caps lead in a bull market and Nicoski believes we’re seeing that now. Energy stocks are beginning to show inflection behavior as well. Another factor Nicoski considers is the high-yield spread versus the 10-year, which is starting to come down, suggesting a recession has been pushed further out. He said, “the market is becoming more confident that we are not going to enter a recession.”
There are some interesting indicators that suggest energy may be reversing, Nicoski said. He added that this market reminds him of 1998, when oil hit $11 a barrel. No one wanted to own energy at that time and technology was a dominant sector.
Currently, capital spending in the energy sector is nonexistent. The prevailing sentiment is that prices will be stuck near $50 a barrel for another decade, while everyone wants to be in technology. In contrast, Nicoski said there are some very attractive energy charts right now, with some signaling the they’ve had their capitulations already.
“The cure to low energy prices is low energy prices,” Nicoski said. “Up through August, there were more than $18 billion in bankruptcies in the energy sector. At some point, we start to take away the ability to produce more energy when you have those types of bankruptcies. … You create bubbles when you get narrow leadership within the market. Leadership … is dominated by technology, and at some point, this is going to turn into blow-off tops, with a parabolic move to the upside in energy.”
Sector Strength Indicates No Recession
Strength remains in the technology sector as well as in materials, energy, financials and industrials. This suggests we will avoid a recession, Nicoski said. The healthcare sector is also signaling inflection, with biotechs making a 180-degree about face in the last few weeks, moving into outperformance.
Nicoski pointed to a broadening trend in market breadth. Financials along with investment banks, brokers and super regional banks, are going very well. Small cap banks have reversed their downtrends and have built excellent bases. In looking at what's propelling the market to move out to new highs in terms of sector orientation, broad participation within a number of sectors indicates that small caps are starting to move into a leadership position.
“Historically, concern over tariffs affects the large caps more than the small caps. Yet the small caps have been bludgeoned. For all practical purposes, large caps held up extremely well, but they're also the most exposed to tariffs, which is highly unusual. I think that was the market moving to defensive posturing. … With that coming off the table, I think that the market is primed and ready to move higher.”
Interest Rates and Markets
An uptick in U.S. interest rates will likely push investors into equities as they sell bonds, Nicoski said. In 2016 when oil fell to $26 a barrel and rates began to move up considerably, the market continued to move higher in a safety trade setup. No one can pinpoint where markets will tumble because rates are moving too high, Nicoski stated. Interest rates should move higher as the global economy strengthens, he added. He would like to see energy move higher, not on the strength of production cuts from OPEC, but as a result of absolute demand growth on a global basis.
“I'm not as concerned about interest rates,” Nicoski said. “The Fed has been quite clear they're not going to push rates up anytime soon. With the downtrends we're seeing in materials and energy, I don't think that we should be concerned about inflation either.”
Copper vs. Gold and Other Commodities
The gold-copper ratio is shifting as Financial Sense Newshour has discussed previously, and copper is now outperforming gold. This is a good indicator of global expansion. If the U.S. dollar weakens to any degree, most commodities should follow emerging markets higher. US oil consumption is unlikely to shift substantially if oil prices go up or down by $10 a barrel, Nicoski said.
“Most emerging market countries have taken out loans in U.S. dollars,” Nicoski said. “If their currencies start to gain strength, they’re going to have more buying power for energy, and it's going to reduce their debt load. From what I see here, I think the market looks absolutely terrific.”
Election Year Dynamics
Ryan Sweet of Moody's Analytics pointed out that markets tend to do well in election years. Some of it is luck, but it also has a lot to do with where we are in the business cycle. This year, tariffs are also playing a big role. President Trump is using tariffs as a tool to negotiate trade deals, Sweet said, with the goal of producing better outcomes for the U.S.
“Ironically, the areas that are struggling are the areas that were supposed to benefit most from the use of these tariffs,” Sweet said. “However, all in all, when we look at the economy's fundamentals, 2020 should be another solid year. I think we'll continue this relatively long streak of strong economies in election years.”
Fed’s Smart Reversal on Rates
The Fed’s aggressive rate hikes in 2018 gave way to three rate cuts this past year. In hindsight, the December 2018 rate hike was a mistake and the Fed signaled rates will be on hold for the foreseeable future. The bar to raise interest rates has been set so high that this is unlikely, Sweet explained.
To hike rates, the Fed would need to see inflation accelerate substantially, running meaningfully above its two percent objective. However, the Fed has had a hard time generating inflation around two percent in this expansion.
“We avoided a recession, and it looks like we should give the Fed a lot of credit,” Sweet said. “They recognized their mistake, they addressed some of the downside risks to the economy from the trade tensions, and they cut interest rates by 75 basis points. The jury's still out as to whether or not they were able to engineer a soft landing this time around. But as of right now, by cutting interest rates, it looks as though the Fed has reduced recession risks, and this expansion should live on.”
Consumers Powering Economy in 2020
With the unemployment rate at a 50-year low and wages rising, consumers are doing well. Additionally, the ISM services sector is still in positive territory and continuing to expand. This should set up strength in the coming year.
Consumers are carrying the economy right now, Sweet said. If we remove consumer spending from GDP the economy would have contracted in each of the last two quarters, highlighting the importance of the consumer in the U.S. economy.
The outlook remains solid for the consumer. The job market is strong, unemployment is low, nominal wage growth is picking up and both inflation and interest rates are low in the U.S. Household wealth is rising and consumer confidence is strong. If we do hit a soft patch in job growth and the labor market weakens, this wouldn’t necessarily be enough to spook consumers, Sweet said. Savings are near eight percent in the in the U.S. which is a decent savings cushion.
“There has been some concern about whether the consumer is over-levered," Sweet said. "Household debt is rising. We have more than a trillion dollars in outstanding credit cards. However, the level of debt really doesn't matter for consumer spending. It's the monthly payments that matter. So the debt service burden is among the lowest since the 1980s. The consumer will be able to keep this expansion going, helping us weather the issues in agriculture, the problems in manufacturing and in trade.”
2020 vs. 2019
The economy could do slightly better in 2020 depending on the setup, Sweet said, but Moody’s is forecasting a slight deceleration in the coming year. U.S. GDP in 2019 is likely going to come in between 2.2 and 2.3% growth. In 2020, he expects closer to 1.7 % GDP growth for the year.
There are reasons for optimism, however, including continued consumer strength and real estate investment expansion. Additionally, financial market conditions have eased substantially since the beginning of 2019, which usually impacts the economy with a lag. We should see benefits from this easing materialize in the first half of 2020. Sweet expects to see U.S. GDP settle in around its potential growth rate of two percent.
The longer the expansion runs, the greater the intensification of risks. Major contrarian indicators could come in the form of developing imbalances in financial markets or the broader economy. Primary causes that can kill an expansion take place when the economy overheats or an asset bubble pops. Neither of these are a threat right now, Sweet said.
“The economy could perk back up in 2020, but I don't think we're going to get back to the three percent GDP growth rate we saw in 2018,” Sweet said. “It's important to remember that the economy in 2018 was juiced by fiscal stimulus. Now, that impact is waning. … If we get any resolution on the trade front or if there's a de-escalation in the trade war … I think business confidence will improve. We’ll start to see business investment pick back up, and that would do wonders for the economy in 2020.”
Where Is Energy Headed in 2020?
Energy has been the worst performing sector all year, serving as the big short of 2019. Everyone has been shorting oil, Puplava said. There has been a disparity between the price of oil and energy stocks.
The oil price bottomed in February 2016 at $26 a barrel, and it’s now back to $58. Meanwhile, XLE, the SPDR ETF and some energy stocks are down as much as 50 to 70 percent. What’s driving this is the narrative that oil demand is falling. OPEC has continually cut production, with more slated to take effect in January 2020.
Puplava believes this is a false narrative. Oil demand is not falling, rather, he said, it hasn’t grown as fast as it has in the past. The reason for this can be found in the global economy. Global demand is still growing by a little over a million barrels a day and we're approaching consumption of one hundred million barrels a day.
Oil Shock Coming
The U.S. shale boom has been the story in energy for the last several years. This can’t continue forever, Puplava explained. There has been a bias to continually overestimate shale supply, which has helped keep oil prices down. The year-over-year increase in production is falling far short of expectations. Few shale players are making money at these prices. Couple this with the fact that markets continue to underestimate demand, and there are several factors that are supportive of oil prices going forward.
In fact, these low prices could be setting up for a supply shock in the coming decade, Puplava said. Shale companies and especially the mid-tier players that originated in the shale patch, have all cut back tremendously on 2020 expenditures. Wall Street wants to see dividends, debt reduction or a rising cashflow from shale companies before it is willing to extend debt further. There have been more bankruptcies in the energy sector dude to small or nonexistent revenues for many of these companies.
Several large organizations, including BHP and Exxon, are betting on energy in the coming decade. Exxon is one of the only players actually investing in exploration upstream rather than downstream, and it is trying to double its production and flow by 2025, because it sees the coming supply gap.
Written by Ethan D. Mizer