Oil continues its assent as markets fret before the Fed

There is a trinity at work in markets now, the oil price rises, stocks and risk sentiment take a knock and then concerns about higher interest rates start to raise their head. Thus, when the price of oil continued to rise on Monday, after a near 10% increase in the price of Brent crude since the start of September, it spelt bad news for stocks and risk sentiment globally, but most notably in the US. Stocks in the US ended last week on a sour note. The S&P 500 closed Friday down some 1.4%, while the Nasdaq was down more than 1.5%. While faltering risk sentiment is a global phenomenon, the US is being hit hard across the board. This is because US stocks have further to fall and are more expensive than their UK and European counterparts, but also because the US stock market is particularly exposed when tech has a wobble.

Why the FTSE 100 is outperforming the US

There is an interesting dynamic in the stock market right now. In the US, both the large cap S&P 500 and the small cap Russell 2000 are falling, the Russell 2000 has been lagging the S&P 500 all year. The FTSE 100 may have been lagging the S&P 500 all year and is up a mere 2% compared to the 16% gain for the S&P 500, yet it has outperformed the US index for most of this month. The reason for this is the oil price. Shell has seen its share price rise 10% in the past month, roughly the same rate of increase as the price of a barrel of oil in the same period. Even leaderless (and feckless) BP has seen its share price rise 7% in a month. The same is not true of the big names in the US. Nvidia is down more than 1.3% in the past month, while Apple is down 1.2% in the past month. The lessons that investors can take from this information is that: 1, the mega tech sector is not untouchable, and is at risk from different factors – including China, which could cause an existential crisis for sector. 2, Bet on tech and hydrocarbons simultaneously, as oil stocks can be a good hedge when Opec is restricting supply. 3, while the US tends to see stock market outperformance, it is always worth being globally diversified.

Fed watch

Oil is the dominant force in financial markets right now, and its impact is being keenly felt in the bond market and in the Fed Funds Futures market. The Federal Reserve will announce their latest interest rate decision on Wednesday, there is a 99% probability that the Fed will hold rates steady at 5.25-5.5% when they meet. The interesting part of the meeting will be the press conference and the accompanying statement, the market will be looking for clues as to what the Fed does next. The data from the US economy in recent weeks has been mixed.  For example, core prices have turned lower however, the momentum in service price inflation has notably slowed in recent months. While NFP data suggests that the rate of jobs growth in the US is slowing, it is not clear from other indicators that the labour market is slowing as quickly as the NFP measure suggests. Bond yields have also moved sharply higher on the back of the spike in the oil price. For example, in June the 10-year yield was averaging 3.7%, the 10-year yield is now 4.3%. However, higher bond yields did not weigh on equities, which are higher than they were in June, even if they have lost momentum in recent weeks, and financial and credit conditions are stable. While economic forecasts have mostly been revised higher in recent months, small cap stocks have come under pressure, because there are some areas and sectors that are of concern to the market, and this has showed up in the small cap sector first. US banks have noticed a softening in credit, with bank credit growth 3m/ 3m virtually flat, although this is better than bank credit growth in the Eurozone.

What the Fed does next

The outcome of this meeting appears to be a foregone conclusion. However, as you can see, the economic picture in the US is unclear right now, with some strong indicators, some signs of weakness if you dig down far enough, and a worrying uptick in core inflation. Thus, investors want to know if the Fed will signal that a further rate hike to 5.5-5.75% is coming in November or December. Right now, there is a 36.8% chance of a 25bp rate hike to 5.5 – 5.75% at the December meeting, according to the CME Fed watch tool, with a larger probability pointing to rates remaining steady at the end of the year. If the Fed sounds concerned about the oil price at this week’s meeting, then there could be a rapid repricing in the Fed Funds Futures market, which could weigh even heavier on stocks and boost the dollar. The market will also be trying to extrapolate from the meeting what this means for rates next year. There is currently a 35.1% chance of rates remaining at 5.25-5.5% by June 2024, this means that the market currently is not expecting any rate cuts from the Fed in the next 9 months. One month ago, the probability was only assigned a 14% chance. Thus, as US growth forecasts have been revised higher, the market has priced out the chance of rate cuts. The risk for traders from this meeting is that the prospect of more rate hikes get priced into 2024, depending on how hawkish the Fed is perceived to be on Wednesday.

Don’t bet the house on a dovish Fed

To conclude, all eyes are now on the Fed, and we expect stock markets to trade with a weaker bias until we get clarity from the US central bank on what they plan to do in the next 6 months. However, as we mention above, the economic data is mixed, so the Fed may be non-committal. The market may take this to be a dovish sign, and thus buy risk on the back of it, but any rally could be short lived. If the Fed sticks to its long-term message that it is still fighting inflation, and if it switches its concentration to headline prices rather than core due to the spike in the oil price, then we could see the dollar continue its rise. The dollar index may be falling on a touch on Monday; however, it is up more than 1.7% in the past month, and we expect the upward momentum to continue, especially vs. the EUR, GBP, JPY and CNY.