Do Oil Markets Signal A Downturn?

Over the last few months, market watchers have become accustomed to a situation, or rather a correlation, that makes no sense. Oil and stocks have tended to move in unison. From a basic, fundamental perspective that is patently absurd. Energy costs are an important factor in the overall profitability of businesses and have a big influence on consumer behavior too, so higher oil should be a warning sign, not an indication that everything in the garden is rosy. This week, though, we have seen signs that the correlation is now fully broken. Stocks have recovered rapidly from the Brexit news, while oil has stayed lower. The question, of course, is which is right?

The recent correlation has come about for two basic reasons. Firstly, from these levels even higher oil is still, as compared to the recent days of $100+ WTI, low and therefore nothing to worry about. Secondly the potential negative effects of higher oil have been less important to stock traders than the implications of oil’s movements for global growth. Both of those things still apply to some extent, but the further we move away from $100 oil the less relevant it becomes.

That leaves us with implications for global growth, and in that respect I would say that it is the stock market, not oil, that is out of whack. There is plenty of evidence to support that theory. First and foremost is what other markets are telling us. I probably have a bias due to being trained in a forex dealing room, but I was always taught that the most reliable indicators of overall economic conditions and prospects are, in descending order: forex, bonds, commodities and then stocks.

Those are the markets that count, and the U.S. stock market is alone among them in bouncing straight back from the Brexit shock. The dollar remains elevated and, sovereign debt, from the U.S. and other developed nations, is at record levels. That is not specific to one part of the curve either; both the 10 and 30 Year Treasuries have touched record low yields. Call me old fashioned, but no matter what central banks are doing, when I see huge demand for dollars and safe sovereign debt, I take that as a warning.

The stock market, it seems, is concentrating on the prospect of more free money from the Fed and seems to have convinced itself that Brexit either will not happen or will have a very limited effect. The likelihood that the Fed will at least delay increases, however, comes from their perception that there are real problems in the global and domestic economies, so to my mind is hardly encouraging. I guess there is a possibility that Brexit will not happen, but, given the promises made that looks unlikely, and if it does the effects will be noticeable. If nothing else, as the story develops in the U.K. the related news will cause volatility in the short term.

Given the choice I will nearly always take the forex, bond and commodity markets over stocks. They are more indicative of the global mood and less subject to irrational moves based on perception and momentum. There are some serious challenges to the global economy on the horizon. Not only do we have Brexit, but also a worrying political trend towards protectionism and, although most seem to have forgotten all about it, China is still in the process of transition from manufacturing to a more advanced economy. All of those things outweigh the stock traders’ delight at more free money, and the oil market’s caution looks far more realistic than the stock market’s optimism.