Stocks continued their winning streak on Friday, at least from the viewpoint of the Dow Industrials which rose for an eighth straight session. But the S&P 500 and NASDAQ Composite finished lower. Over the weekend, a drone missile attack against Saudi Arabia knocked out over 2 million barrels of oil production instantly. How long it will take to restore the field to normal production is unknown at this time, but it will certainly be months if not longer. Houthi rebels from Yemen, in war with Saudi Arabia, claimed responsibility, but the U.S. State Department was quick to blame Iran. Whatever the cause, the price of oil jumped by over 8% and will certainly have an impact on world economics. Futures point to a lower open.
If this attack had happened a few decades ago, the impact would have been much more severe. However, in the interim, both the U.S. and the Soviet Union have developed into oil producers about the size of Saudi Arabia. Moreover, after the oil embargo of the late 1970s, the U.S. built up a large Strategic Petroleum Reserve (SPR) to protect against sudden shortages, whether they be created politically or by Mother Nature. President Trump has already stated that he will use oil from that reserve, if needed, to compensate for the lost production.
Saudi and Russia officials are due to meet today. You should remember that the two countries have reduced production recently to compensate for lower world demand growth. While the Saudis may not be in a position to raise production today from other fields to compensate fully for the lost production, the Russians could increase somewhat. In addition, should prices stay elevated U.S. production from the Permian basin and other fracked oil fields will accelerate production to take advantage of higher prices. The net result is that the loss of 2-3 million barrels per day is a jolt to world oil markets but will not cripple the industry or world economies.
All this presumes no further missile strikes or any further production cuts. The U.S., as noted, has been quick to blame Iran, a likely supplier of missiles to the Houthi rebels with enough range and capacity to strike Saudi oil fields. Certainly, key in the days ahead is the Saudi reaction. If they refuse to blame the Iranians outright, it will be harder for the U.S. to make the case to the rest of the world that Iran is to blame and should be punished further. The annual United Nations General Assembly meetings come up imminently and world reaction to the missile strikes will be front and center. Clearly, Iran has become economically isolated, even assuming some tacit support from the Soviet Union and China. But the U.S. has isolated itself over the past few years and building a coalition to support bold action against Iran will be difficult. With that said, I will leave the politics to others. The economic reality is a body shot to oil markets but not a knockout blow either to the oil industry or to world economic growth. The muted reaction of the futures market this morning seems to agree with that conclusion.
Elsewhere, the big news last week was the sharp rebound in bond yields. In a matter of just a couple of weeks, yields on 10-year Treasuries fell from roughly 2% to under 1.5%, only to rebound within a matter of days to over 1.9%. Overnight, they slipped back again because of the missile attack, but the 2-10-year curve is no longer inverted and recent data suggests strongly that no recession is imminent. Of course, if tariff wars escalate or oil production is impacted further by additional missile attacks, all bets are off. But there are always red herring risks. President Trump has already hinted at the possibility of an interim trade deal that would allow economic pressure from increased tariffs to be reduced. You don’t have to be a rocket scientist to realize that if the economy in 2020 is under pressure from accelerating tariffs, Mr. Trump’s reelection chances would be reduced. He realizes this. Of course, so do the Chinese and there remains a risk that the Chinese will overplay their hand and not give Mr. Trump enough space to find an interim solution that will allow him to still appear strong against Chinese perceived trade violations. The world is full of ifs.
But while the stock market takes ifs into consideration, the bottom line is always earnings and dividends. Solid economic data over the past two weeks supports a conclusion that earnings will recover a bit over the next few quarters. Interest rates remain low. In theory, the recent jump in 10-year bond yields should have been a headwind to stocks, but a P/E of 17-18 times forward earnings is more consistent with a 10-year yield of 2% or a bit higher than a yield of 1.5% or lower. Said differently, the stock market never believed that rates of 1.5% or lower were sustainable. Inflation data last week (both PPI and CPI were reported) suggest inflation is running close to 2%. We live in a bifurcated economic world. Consumer and government spending are strong, while industrial and capital spending are weak. Prices of commodities and other goods with low labor components are weak, while prices for services and products with high labor components continue to rise. The mixed picture is reflected in the stock market. In general, producers of commodities, industrial products and capital goods are weak, while domestic services for IT consulting to restaurants, have been winners. In addition, despite a world economic slowdown, consumers all over the planet continue to spend.
In summary, the oil shock will pass if it is a one-time event. That could be a big if. But until tensions escalate to the point that consumer spending weakens, the economy is OK. Over the next few days we will see if tensions escalate or not. As we all know, President Trump’s instinct is to hit back harder. But he also wants to avoid war or any event that precipitates war. There isn’t a lot of space in between. As for today, oil stocks and beneficiaries of higher oil prices will be today’s winners while companies highly depended on oil prices will come under pressure (e.g. airlines).
Today, David Copperfield is 63.
James M. Meyer, CFA 610-260-2220