It’s time to dispel the myth that crude oil and gasoline are inextricably linked as commodities. While gasoline is indeed refined from crude oil, each should be considered separately due to their distinct supply and demand influences. Although they occasionally exhibit similar pricing trends, as recent events from Iran illustrate, conflating the two can lead to significant misunderstandings regarding energy markets.
Casual observers might find it perplexing that Iran, possessing 10% of the world’s proven oil reserves and ranking second in global crude production, has resorted to gasoline rationing amid rising civil unrest. The reality is that while Iran produces an excess of crude oil for export, its domestic production of gasoline is insufficient to meet internal consumption. This challenge stems from a familiar issue: a lack of investment in refining capacity to keep up with escalating domestic demand.
In 2005, Iran’s gasoline consumption hit around 400,000 barrels per day, with the country importing approximately one-third of that amount, according to the Energy Information Agency. This paradox has made Iran the world’s second-largest gasoline importer, following the United States.
While core CPI may seem under control, the Federal Reserve remains wary that the battle against inflation is far from over.
Today’s FOMC statement reiterated that the primary concern is the potential for inflation to remain stubbornly high. The statement echoed its previous remarks from May but added that “Readings on core inflation have improved slightly in recent months. However, any sustained easing in inflationary pressures has yet to be definitively established.” High resource utilization could continue to exert inflationary pressures, making this caution particularly noteworthy, especially following a positive report on core inflation for May. Many analysts had speculated that this encouraging data would allow the central bank to relax, but that optimism appears to have been premature.
“The Fed is signaling it wants evidence that inflation is decisively down before relaxing its stance,” stated Gerald Lucas, senior investment strategist at Deutsche Bank, in remarks to Bloomberg News following the FOMC meeting.
The government is set to update first-quarter GDP figures, but preliminary estimates suggest the economy expanded by a mere 0.6% in the first three months of this year, based on a real, annualized calculation. In contrast, the real yield on the 10-year TIPS was reported at 2.70%, indicating that inflation-indexed Treasuries now offer a robust yield premium compared to economic growth.
By this gauge, U.S. interest rates seem considerably tight relative to recent economic performance. The relationship between interest rates and GDP growth can shift significantly over time. For instance, in Q1 2006, GDP grew by a strong 5.6%, coinciding with real yields of 2%. Hence, the cost of capital seemed relaxed back then but now appears more constrained.
On an international scale, a recent publication by BCA Research highlighted that bond yields worldwide remain low compared to global economic growth rates. They concluded that “interest rates are not yet restrictive,” suggesting that global equities are likely to experience upward momentum. “A significant rise in the cost of debt is needed to reign in the ongoing bull market in equities,” they advised.
However, caution is warranted: MSCI indices across developed markets have been consistently declining recently. For example, the MSCI EAFE index has dropped by 1% in dollar terms over the past month. In contrast, emerging markets are thriving; the MSCI Emerging Markets index has risen by 3.6% over the same timeframe, with MSCI EM Asia increasing by 5.6% and MSCI EM Eastern Europe by 7.2%.
The Federal Reserve’s FOMC is convening again this week to shape future monetary policy. Based on Fed funds futures, it seems likely that the current rate of 5.25% will remain unchanged.
Whatever decision the central bank reaches on Thursday, it’s certain that opinions will vary widely. We find ourselves in a climate filled with both cautious bulls and confident bears. Amid various worries, the positive signs still emerge, albeit subtly. For those observing the U.S. economy, confusion is inevitable, given the conflicting narratives: hedge fund struggles, subprime mortgage issues, real estate market corrections, rising interest rates, and reiterations of economic downturns on one side, against low unemployment rates of 4.5%, stable jobless claims, and robust consumer spending on the other.
“Seventy percent of Americans now believe the economy is worsened,” remarked Donald Lambro, a columnist for Townhall.com. However, he noted that this pessimism stands in contrast to increasing workforce participation, rising wages and household wealth, and a stock market rally boosting retirement investments.
The discourse surrounding inflation typically centers on its trajectory. Those fixated on top-line inflation, as indicated by the Consumer Price Index (CPI) or Personal Consumption Expenditures (PCE) index, see a clear upward trend.
Conversely, advocates for core inflation measurements suggest they more accurately represent the situation, given that current trends indicate moderation. This disparity in inflation indicators stems largely from the rising price of energy, which directly affects top-line figures but is excluded from core measures.
A recent note from the St. Louis Fed indicates that the widening gap between overall and core inflation may signal concerns for policymakers. Economist Riccardo DiCecio asserted, “It may be premature to conclude that monetary policy effectively maintains price stability if we only consider core inflation, which ignores persistent increases in oil prices.”
Change in capital markets can be gradual or sudden, often challenging prior expectations. The current shift in the financial landscape seems to be more subtle, leaving room for debate. Notably, Real Estate Investment Trusts (REITs) have lagged behind this year, marking a shift that the sector has not typically experienced.
As evidenced in the table below, REITs are currently facing losses for the first time since 1999, when returns were down 2.6%. Since then, they have experienced a historic bull market. For those who invested in Wilshire REIT at 1999’s close, annualized returns through May stood at an impressive 22.3%, in stark contrast to a mere 2.2% for the S&P 500.
The critical question now is whether the REIT boom has reached its limit. No one can predict with certainty, but some reasons lend weight to this consideration. For one, extended upward trends seldom continue indefinitely. After seven consecutive years of growth through 2006, the likelihood of prolonging such a rally diminishes with time.
Former Fed Chairman Alan Greenspan posited last November that the worst of the housing market’s correction was behind us. Current data on housing starts, however, suggests otherwise.
Government reports indicate that May’s seasonally adjusted annual rate of housing starts fell 2% from April and is nearly 6% lower than last November. Year-over-year, housing starts are down by almost a quarter.
Some may point to the low point reached in January, suggesting improvement since then. However, the uptick since that trough hasn’t instilled much confidence that a genuine recovery is in progress.
While the future of the housing market is uncertain, the broader economy has yet to experience any significant shocks. Although this June differs drastically from last year, there remains an air of optimism. Nonetheless, growing concerns about housing’s health indicate that its troubles could pose a larger threat to the overall economy.
Mr. Market is full of surprises, some pleasant and others less so. Presently, the positive seems to dominate in equity markets, largely due to continued consumer spending that has exceeded expectations.
Analysts have been taken aback by this trend. In fact, the median company in the S&P 500 reported a 10.1% increase in earnings for the first quarter, marking the 19th consecutive quarter of double-digit growth, as noted by Zacks. The materials and industrial sectors stood out with earnings gains of 14.5% and 13.5%, respectively.
Joe Sixpack’s relentless spending was highlighted in the latest retail sales report for May, which showcased a 1.4% month-over-month increase—the strongest since January 2006. Reports of the consumer’s demise have proven to be exaggerated.
The future, as always, remains uncertain. Yet, as long as spending continues unabated, the potential for a significant financial downturn may be delayed. The timeline for such a reckoning is unclear, but skeptics of consumer spending capacity have thus far been proven wrong.
Thank goodness for core metrics!
For those looking to maintain a positive outlook on inflation, focusing on the core rate of the consumer price index is essential.
This morning’s CPI report offers a mixed bag. On one hand, top-line CPI rose by 0.7% last month, marking the largest increase since September 2005’s unusual 1.2% jump. This has pushed the annual inflation rate to 2.7%, highlighting a worrying upward trend since late last year.
Even so, the core CPI, which excludes volatile food and energy prices, shows a different narrative. In this ‘ideal world,’ where energy and food costs are not a factor, inflation is nearly negligible. The core CPI rose only by 0.1% last month, a decrease from April’s 0.2% rise. The annual core rate is down to 2.3% for May, down from 2.9% in September 2006, indicating a gradual decline.
This raises the question: which inflation measure represents reality? The answer often hinges on one’s perspective. The central bank tends to favor core readings as they effectively filter out significant price volatility in energy. This focus allows for more credible monetary policy aiming at broader economic stability.
The recent upswing in retail sales has sparked optimism among equity investors. The 1.4% increase in consumer spending for May is the highest gain in 16 months. Yet, in this environment, good news often comes with its share of caution.
Import prices surged unexpectedly, climbing 0.9% last month, outpacing predictions. Likewise, producer price index (PPI) figures for May indicate a resurgence of pricing pressures at the wholesale level. Seasonally adjusted PPI rose 0.9% from April, with an annual increase of 3.9%. This illustrates that while inflationary pressures are present, they may not be catastrophic.
While the core PPI rose merely by 1.6% over the past year, it suggests a steadiness primarily within a narrow range. The real concern arises if the top-line pressures lead to upward movement in core rates. As we await tomorrow’s CPI report for May, these inflation trends remain vital to monitor.
