Episode 9: Qasem Soleimani’s death, US Payrolls and UK construction

This is Before & After from Refinitiv. 

I'm your host. Johanna Botta. In our first episode for 2020, we're going to take a look at the non-manufacturing ISM data to see if they can continue to hold up despite yet another drop in the ISM manufacturing data. 

Then we're going to take a look at U.S. oil inventories, because the U.S. hit on General Soleimani has brought the energy complex right back to the center of market concerns. 

The U.S. non- manufacturing ISM will be released early this week, and will be a good indication of whether the new decade will continue to see the resilience in the services sector that supported markets during 2019. In the last reading, the November non- manufacturing ISM came in below forecasts, with a fifty three point nine reading versus a fifty four point five estimate. The reading was, however, dragged down by a steep decline in the business activity component. This number came in at fifty one point six versus fifty seven the prior month, a complete collapse, and the lowest reading since January 2010. 

Will the positive developments in trade negotiations in December, paired with a strong holiday season and markets making new highs through last month, improve sentiment? And will the non-manufacturing figure continue its divergence from the manufacturing data, which last week made new lows, its fifth consecutive reading in contraction territory?

Agriculture, wholesale trade and construction stood out in last month's report as weak industries. That's not too surprising. As we know, trade and farming have seen very real ramifications from the trade wars with China. But one would expect construction to perk up considering the doveish borrowing environment. And of course, strength was seen in the tight job market reading, which has continued to defy many people's expectations of a slowdown. 

Each year, has its own identity in the markets. Themes and regimes become established early and can set the stage for how market observers need to adjust their strategies. With a much higher bar for further accommodation from the Fed in 2020 than in 2019, economic data points need to be that much more extreme to move the needle. We're going to want to see a rebound in the business sentiment activities reading this month. Another steep decline could indicate that the cuts of 20 19 were not enough, but with stocks already a bit stretched after the year-end rally, plus the additional geopolitical risks, which we will come to later, it's a 50/50 ball on stocks rallying on dovish numbers. 

So we should be watching U.S. Treasury yields on big numbers. Last week the U.S. 2 year, 10 year part of the yield curve steepened to its widest levels since October 2018. In fact, it's been a bear steepener where longer term yields rise faster than shorter term yields, indicating that investors are either reevaluating growth to the upside, or maybe are concerned about inflation and the risks of ballooning debt. 

With that in mind, we should focus on U.S. 10 year yields. Should they rise on the back of a stronger ISM non-manufacturing number? Consensus is fifty four point five. If a beat occurs, coupled with signs that commodities are breaking out, then we should expect longer term yields to reverse at the recent geopolitical weakness, and the U.S., 10 year yields start to head back toward the key psychological 2 percent level. In light of the recent flare ups of tension in the Middle East, we feel that oil prices will be a key driver of the narrative in world markets. And we'll look at inventory supplies this week as well as price action oil to map out what to expect next. 

On Friday of last week, President Trump ordered a drone strike that killed a top Iranian general, Qasem Soleimani. This was an unexpected action that could have serious recourse and saw an almost instant four percent spike in the price of oil. This comes at a time where OPEC has already made a concerted effort to cut oil production and mitigate the global oil glut that has kept energy prices relatively subdued for most of 2019. 

But first, some history. On September 14, 2019, drones were used to attack the state owned Saudi Aramco oil processing facilities at Abqaiq. This attack took half of Saudi's oil production, five point seven million barrels a day off line - 5 percent of the world's total. While no responsibility has been assigned for the attacks, Iran was widely suspected to have been involved. Now why does it matter? Clearly, a sustained tension or worse, a war with Iran would impact oil supplies coming through the Strait of Hormuz. 

Now, what is the Strait of Hormuz? It's a narrow passage from the Persian Gulf. And according to the EIA, it's the world's most important energy choke point. On average, about 22.5 million barrels of oil a day pass through the strait. That is roughly 24 percent of daily global oil production over that period. That's nearly 30 percent of oil moving over the world's oceans. Roughly 80 percent of the crude it handles is destined for Asia. The global economy could not function without those supplies. Last week, when the strike occurred, Brent Crude, the international proxy, rallied to its highest price since, you guessed it, September 14th, and those attacks on Saudi Arabia. 

You can clearly see the price spike in September, but it almost as quickly faded. Seeing Brent collapse ten dollars within a few days. Will this time be different? Is this the price spike that holds this week's inventory? Number and reaction will provide a pointer. We saw a sharp drop last week of 11.5 million barrels of crude, when expectations were for a 3.3 million barrel drop. When the attack in September happened the price of oil quickly reversed. However, inventories were still rising at that point. Another big drop in supplies coupled with simmering tensions, should see Brent break out and challenge the 75 level in rapid fashion. Another key data point to watch is West Texas / Brent oil spread. Basically the U.S. versus the rest of the world. 

Brent Oil is the contract that has a bigger Saudi oil premium priced in and will drive the entire energy complex higher in times of real crisis. This spread should blow out because a U.S. market is now a net exporter and less reliant on overseas supply. A ten dollar spread of Brent over WTI would be a stretched level. If you're looking to fade this news, then do so in instruments unrelated to oil such as the Japanese yen and gold, which both strengthened on the news. In fact, the gold has just made a new six year high. There is much less risk, though, also less reward, in fading the broader market moves. 

There it is. U.S. non-manufacturing, ISM and U.S. crude oil inventories. Refinitiv Data throughout.  

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