Oil Breaks $50: What It Means For The Fed And Your Portfolio

| About: The United (USO)


Oil broke $50 on Wednesday.

Fed feeling pressure to raise rates.

We expect one rate hike at most in 2016. If it does happen, it will likely be in June.

Oil prices broke $50 on Wednesday as the combination of steady demand from Asia and supply disruptions in Nigeria, Canada, and Libya continued to drive the commodity higher. Brent crude ($BRENT) now trades at a high for the year (Figure 1), at levels 80% above where they were three months ago when oil hit a 12-year low. While OPEC producers in the Middle East have continued to pump out volumes to protect market share, oil majors in the US and Europe have slashed their budgets (US rig count is down 75% y/y), helping support a steady recovery in oil over the recent months. A supply side correction was inevitable, as excess capacity was largely responsible for oil's plummet to 12-year lows amidst the backdrop of sluggish global demand. However, the strengthening dollar, which appreciated throughout 2015 against most currencies based on expectations that the Fed was set to begin a round of rate hikes, also contributed. Since the beginning of the year, the dollar has weakened (Figure 2), after it became evident that the Fed would not be raising rates to the extent it had suggested, and we believe this is a big reason for the recovery in oil. With oil pushing prices higher, the market now believes the conditions are ripe for a June rate hike.

Figure 1: $BRENT TTM Price Performance

Source: Stockcharts.com

Figure 2: $USD TTM Price Performance

Source: Stockcharts.com

Many investors are now at a loss as to how to play the S&P 500. Market commentators at the end of last year blamed weak oil for the poor earnings being reported by America's largest companies. The S&P 500 has recovered since January (Figure 3), when the index fell more than 10% to begin its worst ever start to the year. Analysts now point to its rebound, which has coincided with the steady rise in oil prices, as evidence that the two are linked. We do not believe this is the case. The US is a net importer of commodities, and while many companies that comprise the S&P 500 have exposure to oil, even more of them benefit when prices are low. Instead, the poor performances of US multinationals over the past year have first and foremost been the product of dollar strength, which has lowered the value of profits earned in other currencies. There is no significant relationship between the price of oil and the performance of US companies, which continue to disappoint investors despite the recovery in oil. Weak earnings have not prevented stock prices from rising, however, and we believe the S&P's robust climb since January is the result of the Fed backtracking on its rate guidance. With investors expecting a more dovish Fed, share prices have surged, the dollar has weakened, and gold has rallied.

Figure 3: $SPX TTM Price Performance

Source: Stockcharts.com

It should be obvious to investors that asset prices are out of touch with economic fundamentals. In a market supported by central banking, the actions of the Fed mean more to your portfolio than they ever did. Unfortunately, this makes the task of analyzing securities more difficult, as it is no longer sufficient to base a decision solely on a business's economic prospects. In today's world, Warren Buffett's principles are sadly becoming outdated. Now it is central bankers, whose actions are impossible to predict, who largely decide investment outcomes. So what can you expect from the Fed's June meeting? Janet Yellen is at a crossroads. She knows the economy is weak, but her credibility is at stake. The jobs data (on the surface) is strong, and inflation is starting to set in. She will undoubtedly feel the pressure to raise rates. But she also knows that her job is at stake. A victory for Trump would spell the end for Janet Yellen, and she will do everything in her power to perpetuate the idea that Obama successfully carried the US out of recession. The last thing she wants is to induce another around of sell-offs, akin to what happened in January after she increased interest rates a mere 25 basis points.

If the Fed is going to raise rates this year, it will likely be in June, and only be one time. The magnitude will be small, probably another 25 bps. Despite claiming to be data dependent, Yellen will not risk multiple rate hikes. She will use global geopolitical risks and uncertainties surrounding Brexit as excuses to justify her stance, claiming that financial markets cannot handle too much too soon. This will put pressure on the dollar and prevent oil prices from falling much from current levels, even as Iran ramps up production and the wildfires in Canada subside. As for the S&P 500, we expect more of the same. If the Fed does hike in June, we will see a large sell-off, but the lack of additional rate hikes throughout the year will reassure investors and prices will recover.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.