An End In Sight

Here are some of the biggest stories from last week:

• Capital Economics declared that the global monetary tightening cycle has ended.
• Hedge funds cut their net stock exposure at the fastest pace since the 2020 market crash.
• The real 10-year Treasury yield hit its highest level since 2009.
• WTI briefly popped above $95 a barrel for the first time in more than a year.
• Hedge funds boosted their bullish oil wagers to an 18-month high.

Dig deeper into these stories in this week’s review.

Macro

Last month, central banks in the US, the UK, Japan, and Switzerland all kept interest rates unchanged, leading the chief global economist at consultancy Capital Economics to recently declare that “the global monetary tightening cycle has ended”. Put differently, she thinks that central banks worldwide are mostly done hiking interest rates. And this conclusion is not based on some gut feeling: for the first time since the end of 2020, more of the world’s 30 biggest central banks are expected to cut rates in the next quarter than raise them, according to Capital Economics.

The shift in perspective comes in the wake of data indicating a deceleration in inflation across many countries. In the US, eurozone, and several other regions, the pace of price gains has more than halved from its peaks. Meanwhile, there’s growing evidence suggesting that the world economy is slowing, with the OECD recently lowering its global growth forecast for 2024 to 2.7%, from an earlier estimate of 2.9%, as high interest rates weigh on economic activity and China’s rebound disappoints. With the exception of 2020, when the pandemic struck, that would mark the weakest annual expansion since the global financial crisis.

In this new environment marked by gradual disinflation and slowing growth, traders are voting with their feet. They’re currently pricing in no additional rate hikes from most major central banks, and are anticipating cuts from many of those in developing countries. Emerging economies, after all, did a better job than developed ones at navigating last year’s inflation shock, with central banks in Latin America and Eastern Europe acting more quickly to raise rates in response to inflationary pressures. So with price gains cooling in those regions, many central banks there have either started to cut interest rates or are expected to do so soon.

Stocks

As the S&P 500 sold off in the second half of September, hedge funds increased their bets against stocks, with one measure of their market positioning seeing the most significant drop since the March 2020 pandemic crash. This comes after this year’s stock market rally, driven by enthusiasm over AI, starts to fade, prompting hedge funds to ramp up their short positions. That resulted in a 4.2 percentage points drop in the funds’ net leverage (a gauge of risk appetite that measures long versus short positions) to 50.1% – the most substantial week-on-week fall since the pandemic's market selloff in 2020, according to Goldman Sachs.

The recent surge in pessimism is mainly driven by the Fed’s resolve to keep interest rates elevated for a while, putting a strain on already stretched market valuations. At the peak in July, the S&P 500 traded at a forward P/E of 20x. That’s 27% above its average over the past two decades – even though interest rates today are more than three times higher than the average over that same period (valuation levels should be lower when interest rates are higher, all else equal). The tech-heavy Nasdaq 100’s valuation is equally as stretched: despite a drop in September, the index is trading at more than 31 times annual earnings – lower than the frothy days of 2021, sure, but higher than almost any point in the past decade.

Further denting valuation levels are rising real (i.e. inflation-adjusted) yields. See, after being stuck in negative territory for most of the pandemic years, real Treasury yields hit multi-decade highs last week. Real yields are seen as the true cost of money, so when they rise, it makes borrowing more expensive and reduces the appeal of many assets – especially speculative ones (like unprofitable tech stocks or crypto), ones that don’t pay any income (like gold), and ones with long-term earnings prospects that now have to be discounted at higher rates (like stocks belonging to Big Tech).

Commodities

Things are really heating up in the oil market, with WTI briefly popping above $95 a barrel for the first time in more than a year last week after surging on Wednesday. The jump was spurred by a closely watched report that showed inventories at Cushing, a key oil storage site in the US, dropped for the seventh straight week to just below 22 million barrels. That’s the lowest level since July 2022 and brings inventories close to operational minimums (i.e. the oil storage site is nearing the lowest amount it needs to function properly).

The bigger-than-expected drop further highlights how fast the oil market is tightening, mainly because of supply cuts from Russia and Saudi Arabia set to continue until the end of the year. Last month, OPEC forecast that the global oil market will face a supply shortfall of more than 3 million barrels a day in the fourth quarter, potentially the biggest deficit in more than a decade. That, combined with resilient demand in the US and China (especially as the latter gears up for a surge in international travel ahead of the Golden Week holiday), has many market watchers saying that $100-a-barrel oil is inevitable.

Hedge funds certainly seem to believe that $100 oil is on the horizon, and they're putting their money where their mouths are. In fact, their net long positions in oil futures recently hit 527,000 contracts – the highest level in 18 months. That’s equivalent to more than 500 million barrels of oil, or about five days’ worth of global demand. But what’s good for hedge funds won’t be good for the economy. See, if oil does hit $100 by the end of the year, then that would represent a more-than-40% surge since the end of June. That would only add more fuel to the inflation fire, potentially forcing central banks to resume rate hikes or, at the very least, keep interest rates higher for longer.

This week

• Monday: US ISM manufacturing index (September), eurozone unemployment rate (August).
• Tuesday: Australian central bank interest rate announcement.
• Wednesday: Eurozone retail sales (August), US factory orders (August).
• Thursday: German and US trade balance (August). Earnings: Constellation Brands.
• Friday: Japan household spending (August), US labor market report (September).