September 11, 2023Scroll down
The CIO’s Take:
We’ve been writing for some time about an imbalance between oil demand and supply—the latter affected not only by years of underinvestment, but also OPEC+ interventions like that experienced last week—as creating bullish conditions for energy commodities (part of our tactical asset allocation) and firms in the sector (which we hold in our active stock portfolios). We continue to see that story playing out, but increasingly view rising energy costs as a major risk to the soft landing narrative, pushing the Fed to stay restrictive for longer than the market currently expects. Data like last week’s ISM non-manufacturing PMI, showing a surprisingly strong US economy, will only add to the Fed’s determination. Meanwhile, as illustrated by Arm’s upcoming 6x oversubscribed IPO, we don’t see investors adequately pricing in such risks, which keeps us on a relatively cautious footing: underweight stocks and waiting for the curve to back up further before extending duration in our bond portfolio.
Saudi Arabia, Russia extend output cuts
The energy sector got another shot in the arm last week, when it was announced on Tuesday that Russia and Saudi Arabia had agreed to extend previously implemented oil production cuts, combining to reduce supply by an additional 1.3 million barrels/day through the end of this year. That reduction in supply comes on top of nearly 1.7 million barrels/day in existing voluntary output cuts pledged by members of the OPEC+ coalition through December. This doesn’t come as a complete surprise, as Saudi Arabia had committed back in June to the million-barrel daily reduction, starting in July. They extended that cut twice through the end of September, making Tuesday’s announcement the third such extension. For its part, Russia had reduced crude exports by 500K barrels/day in August, with a further reduction of 300K barrels/day in September, now extended through the end of the year. Despite announcements like this becoming something of a routine in 2023, both the magnitude and duration of OPEC+ cuts have exceeded market expectations. In response, Brent crude prices reached $90/barrel on the heels of last Tuesday’s news, marking their highest since mid-November 2022.
Higher prices is the whole point
The obvious rationale for Saudi Arabia and other members of OPEC+ to restrict supply is to put a floor under the price of oil. The preferred level seems to be north of $90 per barrel, a price at which many nations in the group get more comfortable supporting their fiscal budgets. That level also better motivates global capital investment in energy exploration and extraction, ensuring adequate future supply. In the near term, as its expensive war against Ukraine drags on, Russia has special impetus to push for elevated oil prices. From the looks of last week’s price action, extended production cuts are serving their purpose, and we expect this dynamic will keep the market tight during a part of the year usually characterized by seasonal weakness in the oil market. Along those lines, we note that American Petroleum Institute (API) data showed a decrease in crude inventories by 5.5 million barrels last week, following the previous week’s 11.5 million barrel draw—clear symptoms of a meaningful undersupply, and a bullish indicator for energy, in our view.
Upside risks for inflation
Of course, while we expect tight supplies to boost energy commodities and companies with significant exposure, the developments just described have implications for the broader economy. For many companies, and certainly for households, such trends promise one thing: higher costs. That strain is already salient in the transportation sector, where OPEC+ production cuts and low inventories have led to surging diesel prices, up over 40% since May (see below), prompting a sudden uptick in trucking expenses.
Likewise, a number of US airlines, including United, Alaska, and Southwest, have recently expressed concern about a rapid rise in the price of jet fuel, also up around 48% since hitting lows for the year in May. As higher energy prices pass through to the cost of a plane ticket or the rate to ship a package, headline inflation is likely to push higher, complicating the work of the Fed and other major central banks. Indeed, we see increasing energy costs as a significant risk to a soft landing scenario, as rising ‘last mile’ delivery expenses become harder to force on increasingly budget-conscious consumers, cutting into companies margins. We also note that demand has been depressed in light of China’s slower-than-expected recovery, creating additional upside risk to energy prices and inflation if the world’s second-largest economy and one of the greatest sources of energy demand in recent years gets its growth back on track.
Strong services sector sparks inflation fears
Speaking of a soft landing, some investors might wonder why a surprising pickup in services sector activity reported in last week’s Institute for Supply Management (ISM) non-manufacturing PMI actually caused the market to dip on Wednesday. Shouldn’t resurgent strength in services be good news for the market—evidence that the economy remains robust, despite restrictive Fed policy? The consensus seems to have been that an increase in the non-manufacturing PMI from 52.7 to 54.5, its highest level since February, rather suggests the Fed hasn’t done enough to curb inflation and may need to keep rates elevated for longer. Taking a closer look at the ‘prices paid’ sub-index underscores that anxiety, with that statistic marking a second consecutive month-over-month increase after consistent declines over the last year and a half.
‘Good’ news belies risk to stocks, bonds
The ISM report is just the latest in a series of positive data points on the US economy, ranging from consumer spending to the housing market, fueling optimism toward continued expansion. As of last Friday, the Atlanta Fed’s GDPNow estimate pegged Q3 growth at 5.6%. But, again, good news for growth could be bad news for Fed policy, with the US central bank’s top concern at this point undoubtedly a possible resurgence and entrenchment of inflationary pressure. As such, we agree with traders’ decision in recent months to reduce their expectation for rate cuts in 2024, though we think the market is still overestimating the prospects for easing over the next 12 months. Meanwhile, with a range of factors we’ve discussed—Treasury issuance, concerns over the US budget deficit, and looming quantitative tightening—threatening to put upward pressure on the long end of the curve, we see the added pressure of a strong economy creating additional risk of longer-term yields going even higher in coming weeks. As such, we continue to favor an underweight to stocks and duration.
Chip stock to be biggest tech offering this year
UK-based chip designer Arm, owned by investment holding company SoftBank and dominant in the market for processors inside mobile phones, will price its much-anticipated IPO on Wednesday. The firm had already made waves last Tuesday updating the price range for the listing at $47 to $51 per share, putting its valuation at up to $52 billion—compared with SoftBank’s purchase price of $32 billion back in 2016—and easily making it the year’s biggest tech IPO. Over the weekend, buzz around the offering increased, with reports emerging that Arm’s share sale was six-times oversubscribed and that the firm was considering asking investors to price it even higher than the previously determined range. SoftBank will be especially happy with brisk demand for the chip company’s shares, no doubt, considering Arm’s revenue growth had been stagnant over the last year, hit by slumping smartphone sales (see below).
Another risk faced by prospective investors in Arm is that 25% of its sales derive from China, a market in the midst of its own macroeconomic challenges, and one in which a company like Arm doesn’t enjoy complete control over its operations. Even so, with a valuation at the high end of its range implying a trailing P/E of roughly 100x, investors appeared willing to overlook such concerns in pursuit of AI-fueled growth and what they hope could be another Nvidia-like jackpot for shareholders.
Arm’s IPO a litmus test for tech rally
The fate of Arm’s IPO holds significance beyond a win for SoftBank. In the pessimism that followed Russia’s invasion of Ukraine and the Fed’s aggressive pursuit of its own fight against inflation, many of Silicon Valley’s most prominent tech startups reconsidered their listing plans, deferring a share sale until sentiment improved. That hasn’t made things easy for venture capitalists, themselves facing tighter credit conditions as a result of the Fed’s hawkish moves. According to Refinitiv, fundraising by US-based VCs plummeted 60% in the first half of 2023 versus a year prior. Even more telling, venture-backed exits saw a dramatic 80% decline since last year. A revitalized IPO market would certainly help on that front. A strong showing for Arm when investment banks close the books this week would also speak to a continuation of exuberance for anything linked to AI—possibly further inflating a bubble, depending on one’s opinion as to the theme’s fundamental merit.
Note of caution on post-IPO returns
In an environment like we’ve experienced over the last 18 months, institutional investors will undoubtedly be skeptical of tech offerings like Arm’s. Judging by past IPOs’ post-listing performance, such caution is wise. According to a 2021 Nasdaq study, nearly two-thirds of IPO stocks from 2010-2020 failed to match the broader market return three years after listing. That result is a testament, in part, to investment banks’ marketing abilities and IPO subscribers’ tendency to overpay for an exciting growth story. As it happens, SoftBank experienced that volatility in IPO returns just last week, as one of the companies it backs, online mortgage lender Better Home & Finance Holding, saw its share prices tank by more than 95% in its first day of trading on the Nasdaq.