Oil markets got a shock in September when a major Saudi facility was attacked, taking down 6% of world output and causing prices to spike 14%. Back in 2011 when the Arab Spring took out the Libyan government and 3% of world supply, oil rose about 30%. Previous geopolitical shocks also produced much bigger price reactions. Moreover, WTI spent the following weeks giving up all the gains from its post-attack high of $63. This underlines the importance of context. With the relentless production growth, American oil essentially acts as a check on prices. Oddly, Permian Basin, where most of the production growth comes from, produces light, sweet oil which is not a ready substitute for the heavy, sour sort that Saudi Arabia churns out. It highlights the overarching concerns about economic headwinds from trade war and global economic slowdown.
Although volatility for oil has come back down to pre-attack level, there has been a structural shift in oil options for the last few weeks. Many have noted the abnormal, persistently higher implied volatility for out-of-the-money calls relative to puts (abnormal because market participants typically prefer puts to calls for downside hedging). Underneath the calm surface, there is elevated fear of more upside shock. Whether this translates into a jumpy market remains to be seen.
Gold and silver, on the other hand, have retained much of the gains since the renewed Fed rate cut and trade tension escalation this summer. As we wrote earlier this year, precious metals generally benefit from low interest rates, high inflation, and safe haven demand. The current macro environment presents two out of three favorable conditions. Headwinds from the European and Chinese economies, as well as an outperforming US economy are going to cause central banks around the globe to continue easing. US yield advantage will likely draw capital inflow and perpetuate dollar strength. What’s hard to gauge is the second order effect of a strong dollar, which Trump has made clear he hates because it hurts American export. The trade war has morphed into a tech war and can easily turn into a currency war. Interest rate and quantitative easing are becoming less effective in late cycle, which leaves currency manipulation as the most attractive tool to goose the economy and boost asset prices. Now that the Chinese yuan has broken the closely-watched 7.0 threshold, and the ECB has lowered rates amidst growth and political headwinds, the threat of escalation is higher than ever.
Ray Dalio has recently written a few pieces on the hazardous path of the current state of affairs, drawing from the 1935-1945 analogy. Runaway wealth gap and the transition of power from one superpower to the next is rarely peaceful.
Hence, our near term base scenario is as follows:
- Trade war escalates and risk sentiment deteriorates
- Worldwide growth slows but US economy still outperforms
- Central banks around the globe continue ratcheting down rates; Fed to start new easing cycle
- US capital inflow continues, adding downward pressure on treasury yields
- Bond rally continues; safe assets rally despite low inflation
- Strong gold, weak oil/base metal should continue into the rest of year
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