Peak US-phoria? Not yet

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Good morning. France sacked its Prime Minister Michel Barnier yesterday in a no-confidence vote over his handling of the budget. French bond yields jumped in the week prior to the vote but were only slightly up yesterday. The Euro was flat against the dollar — suggesting that investors expected Barnier’s defeat. Unhedged is nominally a US markets newsletter. But markets, like birds or fish, have limited respect for borders. Tell us what we should say about European bonds: robert.armstrong@ft.com and aiden.reiter@ft.com.

Sentiment and bubbles

The past two letters, about whether the US is in a bubble, drew a lot of responses. One came from a veteran asset manager. He wrote:

I think it’s folly to discuss “a bubble that’s about to pop” versus “a bubble that’s not about to pop”. I’ve never seen anyone accurately predict the time when a bubble would pop. I don’t know how one would go about doing that.

This is, I regret to say, a good point. I claimed that the US is in a bubble, but it is not ready to deflate. How could I know that? Bubbles are deflated by surprises. And surprises, by definition, are something you don’t see coming. 

Let me be clearer. There are two key characteristics of a bubble: extremely high valuations and extremely high sentiment. In the US, we are there on valuation. Sentiment, though, is not quite extreme enough to allow for massive disappointment and a devil-take-the-hindmost race for the exits, which is how bubbles end. My guess is sentiment will get there as president-elect Donald Trump stamps his foot on the economic gas. But that is speculation on my part.  

On this point, Duncan Lamont of Schroders wrote to say that the AAII survey of retail investors, which I referred to yesterday, has actually been showing increasing bearishness recently. Again, while it pains me to admit it, he’s correct. When I look at the survey, I look at the bull-bear spread (the percentage of respondents who say they are bullish about the next six months, minus those who say they are bearish), using an eight-week rolling average. Here’s what that looks like: 

The general trend has been up since late 2022, and the current level is quite high. But this year, the trend has been mostly sideways, and the very recent trend is down. That’s not euphoria. Other sentiment indicators — such as flows into US equity funds — do look euphoric. But in a full-blown bubble, euphoria is everywhere.

Energy prices

Donald Trump wants cheap energy. He has set the goal of cutting prices “by half at least” in the first year of his administration. That’s hyperbolic, but the set-up for a sustained decline is pretty good. Global oil production is near an all-time high, and Trump wants to boost US production further. Global demand is starting to plateau. Natural gas is already cheap, and could get cheaper if the US improves its infrastructure.

The key variables that will determine if prices fall, and by how much: 

• Opec+: The “shadow around the markets” right now is Opec+’s production, says Ed Morse of Hartree Partners. Saudi Arabia cannot seem to keep its partners in line on supply restrictions. Voluntary production cuts have been extended to 2025, but most analysts do not think they will last long. If the cuts are abandoned, this could bring up to 6mn barrels per day online — increasing global production by about 5 per cent.

• Global growth: Waning global growth — particularly in China — is a headwind for oil prices. Global consumption growth has been flat or negative for the past three quarters, and the US Energy Information Administration projects that average consumption growth will be even lower in 2025. Analysts expect that oil demand in China, currently 15 per cent of global oil demand, will peak next year. Tariffs could exacerbate the slowdown.

• War in the Middle East: Trump wants some form of a cease fire — which would, in theory, bring lower prices. But Helima Croft, head of commodity strategy at RBC Capital Markets, points out that oil markets have learned to look past the Israel-Hamas war. Prices have only jumped when Iran and Israel have engaged in brinkmanship. A cease fire might therefore have only a limited effect. And if Trump revives Iranian oil sanctions, up to 1mn barrels of oil, or 1 per cent of global production, could come out of the market, Croft reckons.

• Venezuela: Trump’s first administration was hawkish on Venezuela. It imposed sweeping sanctions on the country, including financial restrictions on its state-owned oil producer. His next term could be hawkish, too, and he could squeeze Venezuela’s oil industry further, impacting up to 835,000 b/d. But given his focus on limiting migration, Trump’s team may be wary of applying more economic pressure to the region.

• Natural gas exports: The US LNG market is mostly insulated from global pressures, but that could change. According to Goldman Sachs, the industry is getting ready to increase exports of LNG by scaling up infrastructure, capitalising on higher European prices. That would limit US supply and bring up prices in 2025.

• War in Ukraine: A cease fire would probably not have an impact on oil prices but could potentially lower US natural gas prices. If EU countries stop weaning off Russian natural gas, European prices would come down and disincentivise US exports.

• US production: Trump’s Treasury pick Scott Bessent has said he wants to boost US oil production by 3mn b/d — a 25 per cent jump in US production, and a 3 per cent rise in global output. Could deregulation really provide that much of a lift?

It makes sense that Trump values cheap energy so highly. Lowering gas prices is good American retail politics. According to research by Joanne Hsu, who leads the University of Michigan consumer sentiment index, concerns over high gasoline prices after 2022 helped keep consumer sentiments lower for longer than in past inflationary episodes. Gas prices are a key way that consumers “see” inflation. 

Cheaper oil prices would help domestic manufacturers and households weather the inflationary impact of tariffs. With the US a net exporter, it’s hard to neatly say how lower oil prices will affect GDP growth. But even if it’s a wash for economic growth, it will help sentiment, which would help Trump sell his agenda. And if Trump’s tariffs, tax cuts and immigration restriction together prove inflationary, cheap energy might make things easier for the Fed, too. While the central bank’s preferred inflation gauge is CPI excluding food and energy, cheaper oil feeds through to other prices. And what is more, low prices at the pump could shield the Fed from public criticism if it raises rates.

But there is a catch. If oil does fall by half — to $36 a barrel, based on yesterday’s Brent price — US shale oil output could grind to a halt. According to the Dallas Fed, the average break-even price to profitably drill across the US is about $65 per barrel. Below that level, US production will “start dipping quite fast”, said Henning Gloystein at the Eurasia Group. Trump wants America to drill baby drill. If oil falls under $40, that ain’t happening.

(Reiter)

One good read

Qualitynesia.

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