I mostly manage to lead a car-free existence during the workweek, trading Toronto traffic jams for the pleasures of cheek-to-jowl public transit. But the weekends are another matter.

This past one included a trip out of town for a double-header of youth baseball, our annual pilgrimage to the apple orchard, and a jaunt downtown with family in tow for a last look at the youthful Blue Jays. All three were grand successes in their own right, yielding a handful of base hits, bellies full of previously unheard-of “Silken” apples and a rare Jays victory (over the mighty Yankees, no less).

The common thread running through all of these events was how we travelled to them: via a gas-powered motor vehicle. Such indulgences will now become a more costly proposition as a result of the sudden disruption of Saudi Arabia’s oil production overnight Sunday. More on that below.

Global Investment Outlook:

• Our flagship quarterly publication is now available, with a lead article entitled “Slowing growth, mounting risks”.

Saudi oil:

• The headline news of the past 24 hours is that key components of Saudi Arabia’s oil infrastructure have been damaged by a series of coordinated attacks using drone and missile technology.
• Iran-backed Houthi rebels in Yemen are claiming credit. But the U.S. insists Iran was the direct antagonist, saying there is “no evidence the attacks came from Yemen.” Iran has denied this.
• One thing is clear: the timing is tricky. Global oil inventory levels were already lean. The global economy was already drooping. And Saudi’s state-owned oil champion is set to go public in the not-too-distant future.
• Oil prices have spiked, up by nearly 15% on the day to US$69 for Brent and US$63 for WTI. This is the largest single day percentage increase since Iraq invaded Kuwait in 1990.
• Saudi Arabia has lost more than 5 million barrels/day of production capacity. That represents more than 40% of the country’s production and around 5% of the global supply of oil.
• If a 5% hit to the global oil supply sounds trivial, it is important to appreciate that the elasticity of supply and demand are both extremely low in the oil sector. In other words, it is hard to persuade people to use less oil on short notice. It is equally hard to increase supply elsewhere without advance warning. As a result, large price movements can result from relatively small supply-demand imbalances.
• Case in point is the global oil shock of 2014—2016, which saw oil prices fall by roughly 75% in response to a mere 2% surplus of oil supply over demand. To be fair, this doesn’t mean that oil prices must rise by 188% now as this supply outage is thought to be temporary, meaning that the supply may be able to adjust more quickly than in past. Furthermore, Saudi Arabia has 188 million barrels of spare capacity spread around the world, meaning that it could theoretically fill a 5 million barrel hole in the oil market for 37 days, by which time presumably some fraction of the country’s disabled oil production will be back online.
• Other OPEC nations have so far indicated that they do not plan to act as a counterbalance by increasing their own oil production, though the potential exists. For the moment, we assume they do not alter their production. OPEC recognizes it is not in their best interests for high oil prices to persist for a lengthy period as that encourages additional production from U.S. shale producers and motivates consumers to pivot toward more energy-efficient products. But they are likely more than happy to harvest increased profits over the short run until Saudi Arabia is up and running again.
• The attacks have hit both the Abqaiq oil processing facility – responsible for 7 million barrels per day of output – and also the Khurais oilfield which has a production capacity of 1.5 million barrels per day.
• Some fraction of the supply outage is thought to be of a precautionary nature and thus capable of recovering fairly quickly. However, real damage has been done to the infrastructure. Initial estimates that these could take a few weeks to repair have now stretched into months.
• From a geopolitical perspective, while this event was not precisely anticipated, we have been flagging for some time that geopolitical risks are presently higher than usual – with the U.S.-Iran relationship sharing centre stage alongside U.S.-China trade negotiations and the Brexit saga in the U.K. Iran is already alleged to have downed several U.S. drones, disrupted Iraqi pipelines and interfered with the flow of oil tankers through the Strait of Hormuz. Despite all of this, we believe the worst-case scenario of an outright war between the U.S. and Iran is still unlikely. While the recent attack increases the risk of retaliation, note that President Trump recently expressed a desire to recommence negotiations with Iran. And, Iran-hawk Bolton recently departed from the White House.
• In a world of elevated geopolitical risks in the Middle East, a larger than normal risk premium is arguably justified on the price of oil, even after Saudi production has been restored. It is not easy to defend the Middle East’s sprawling energy infrastructure from drone attacks.
• From an economic standpoint, higher oil prices are usually a negative for global economic growth, though not all models concur with that interpretation. It is a murky subject. This is in large part because the world in aggregate is, by definition, neither an oil importer nor an oil exporter.
• Oil producers such as OPEC nations naturally benefit from higher oil prices. Canadian growth theoretically benefits by around 0.15% for every year that oil prices remain 15% higher than before.
• The U.S. economy is still a net energy importer and used to suffer badly when oil prices rose, but its nimble and expanding oil sector has now largely neutralized that effect. Of course, there are still sector-level implications, perhaps most importantly that consumers dislike rising prices at the pump. This is a particularly critical observation at a time when the consumer is acting as a key bulwark against recession risks.
• Other net oil importers such as the Eurozone and Japan will slow modestly in response to higher oil prices.
• Should the oil price increase be sustained, headline Consumer Price Index (CPI) prints in the developed world would rise by as much as 0.75ppt. This would take the U.S. metric from modestly below target to modestly above.
• That said, for all of this feverish analysis, it is important to keep the matter in perspective. A 15% oil price increase is certainly a rare event for a single day, but oil markets regularly gyrate by more than that over the span of months and years. As an illustration, between December 2018 and April 2019 the price of oil rose by roughly 40% and the world didn’t end.

Higher yields:

• After so much focus on plummeting bond yields over the past few months, it wouldn’t be fair to ignore the opposite trend that has lately taken hold. From a low of less than 1.50% on the U.S. 10-year bond, yields have since increased to nearly 2.0% as of mid-September.
• To be fair, even a coupon in the vicinity of 2.0% is still quite low by historical standards. It remains in line with the (gradual) downward trend in yields that has played out since October 2018.
• What has motivated the spark in yields? We hypothesize that it has to do with a mix of better trade news, recalibrated expectations for the U.S. Federal Reserve, better Brexit prospects and higher inflation (even before oil prices jumped).
• It is not surprising, then, that the increase in nominal yields is roughly equally the result of higher real yields (relating to growth-related developments) and higher inflation expectations (resulting from the inflation readings).
• For the recession watchers among us (everyone?), one happy outcome is that the U.S. 2yr-10yr spread has now returned to positive territory. This reduces the number of metrics signaling recession by one.

Hopeful trade overtures:

• The trade narrative over the past few years has been mostly negative, dominated by rising tariffs and slowing trade flows. We remain skeptical that the world will revert to pro-globalization mode in the near term: the U.S.-China conflict is too structural and global populism has not yet obviously peaked.
• That said, a number of hopeful trade developments have nevertheless come together over the past week, creating greater optimism in the market.
• China appears to be making a variety of small concessions to the U.S. in advance of face-to-face negotiations in the coming month, presumably in the hope of striking a deal.
• China now says it will exempt some large Chinese importers from tariffs on U.S. pork and soy products. Some Chinese companies are now said to be making inquiries with U.S. producers and the country is also rumoured to be preparing certain intellectual property concessions.
• Chinese tech giant Huawei has also mused out loud about possibly taking the radical step of selling its 5G intellectual property to a Western company that could then implement the technology itself and capture a large fraction of the Western market without fear of Chinese spies embedded within the hardware. Should developed nations remain reluctant to put Huawei hardware at the heart of their data networks, this might be the next best way for Huawei to monetize its technology. It is a fascinating thought, though not obviously on the cusp of happening.
• For its part, the U.S. has now spoken about possibly rolling back its most recent round of tariffs on China, though not the tariffs on the original $250B of goods.
• Against this backdrop, the coming U.S.-China negotiations now appear to have a better chance of achieving a major trade breakthrough. However, we still put the odds at less than 50%.
• Elsewhere on the trade front, and constituting a notably less trade-friendly development, the European Union just lost a longstanding (15-year old!) dispute with the U.S. at the World Trade Organization. The WTO has concluded that the EU was subsidizing major aircraft maker Airbus. In turn, in something of a bizarre outcome – given that the WTO spends much of its time these days agitating against U.S. tariffs – the U.S. has now received WTO permission to impose significant tariffs on the EU until such a time as it manages to recoup its losses from the longstanding Airbus subsidy. The specific dollar amount is not yet clear, but the figure may run into the tens of billions of dollars and the tariffs are not restricted to the aerospace sector alone. This is an inauspicious appetizer to the U.S.-EU trade negotiations that are expected to take place in the coming months.

Fiscal stimulus:

• The ECB has now joined the U.S. Federal Reserve (and a host of others) in delivering monetary stimulus in an effort to stabilize a wobbling global economy.
• Expectations were high in the lead up to the decision, and the first blush interpretation of the decision leaned toward disappointment given that:
  • the ECB opted to slice its deposit rate by just 0.1ppt rather than 0.2ppt
  • the size of its quantitative easing operations will be fairly tame (up to 20bn euros per month) when compared to its peak buying spree in 2016—2017 (80 billion euros per month).
• That said, markets came around fairly quickly to the ECB’s plan, thanks in part to its comprehensiveness – rate cuts, a tiering system to minimize damage to banks, quantitative easing and enhanced liquidity injections for banks – but most of all because of the power of the conditional guidance that was attached to the quantitative easing (QE).
• The conditional guidance promises to continue printing money and buying bonds until just before the ECB next raises rates. To the extent rate hikes aren’t even a twinkle in anyone’s eye at this point, that suggests a lengthy period of QE which will add up to a substantial sum of stimulus. Rate hikes are unlikely to occur until Eurozone inflation is clearly well on its way to the central bank’s nearly 2.0% target. The same is now true of QE. Given the depths of Eurozone inflation expectations and the parallels with 1990s Japan, there could be quite a lot of European monetary stimulus to come.
• ECB President Draghi has now concluded his last meeting. We have every reason to believe that the transition to Christine Lagarde will be seamless.

U.S. inflation defies the pack:

• In contrast to chronically depressed inflation in Japan and the Eurozone, we are much less concerned about U.S. prices. True, the country suffers from a low-grade version of the same illness: an aging population, slower population growth and a flatter Phillips Curve. But the problem is much less acute.
• Case in point, U.S. core CPI has just increased to 2.4% YoY, modestly above the central bank’s target. This is a far cry from earlier experiences during the post-crisis era when deflation was mere inches away.
• True, headline CPI is still just +1.7% YoY (though the recent oil price spike could take it over 2.0% in short order) and the core PCE deflator – the Fed’s preferred measure – is merely +1.6% YoY.
• But it is no less relevant that other (arguably superior) measures of the inflation trend all operate between 2.2% and 2.9%. These measures include the trimmed-mean CPI, the weighted median CPI and the NY Fed’s Underlying Inflation Gauge.
• The point is not that inflation is especially high or problematic. Instead, the point is that it isn’t acutely low.

Fed ahead:

• It is a busy week ahead for major central banks.
• On the heels of the ECB’s wall of stimulus, the Fed is likely to follow up its initial July rate cut with another tame 25bps cut.
• A 50bps cut just isn’t justifiable when one combines the latest inflation readings with the recent positive trade rumblings and the surprising increase in the ISM Non-Manufacturing Index.
• That said, the economic outlook published alongside the decision is likely to be trimmed slightly – in keeping with a parallel downward trend in the consensus outlook and given the general slowing of economic growth. Q3 GDP is only tracking 1.8% annualized at present.
• The dot plots will have to come down to reflect the fact that only a minority of Fed participants recommended rate cuts as of June, and yet rate cuts were delivered with just two dissents in July. The question becomes whether the majority of forecasters will alight upon just two cuts for 2019, or whether they will also price in a third cut for later in the year. We suspect they will.
• Other central banks will also be busy this week, though the market does not expect additional easing from the Bank of England or the Bank of Japan just yet.

Next U.S. fiscal hurdle:

• A brief word on U.S. fiscal affairs.
• Having belatedly resolved a government shutdown in late January and then increased the U.S. debt ceiling in August, the next hurdle will be to pass a continuing resolution to keep the government funded past the end of the fiscal year on September 30.
• Expectations are that this should prove fairly straight forward. The House of Representatives is likely to approve legislation to delay a further shutdown for at least a month or two.
• But let us not forget that Congress is presently divided between Democrats in the House and Republicans in the Senate – nothing is automatic so long as this arrangement persists.

Auto strike:

• It is perhaps a reflection of the recovery of the job market that nearly 46K U.S. auto workers were sufficiently emboldened to go on strike at General Motors over wage and health benefits. This is the first strike by the United Auto Workers Union since 2007.
• That date is ominous in that 2007 was the year that the U.S. economy started to stumble, ultimately culminating in a deep recession in early 2009. It is hardly the case that the strike created the recession, but it did reflect the tightness of the labour market at that time – a classic late cycle signal and an indication of vulnerability to recession.
• The labour market is arguably in a similar position today, with the lowest unemployment rate in decades and private-sector wage growth that has accelerated to 3.5% YoY from a low of 1.2% in 2012. Fortunately, there don’t appear to be as many recession triggers this time around: debt excesses are more limited and banks are not obviously overextended.
• Depending on how long the strike lasts, signs of it could temporarily appear in the job numbers, but it is unlikely that the event will prove large enough to palpably depress the national GDP figures.