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  1. Home
  2. / Investing

Is Stagflation Really That Hard to Trade?

What OPEC and markets are not set up for is pure demand destruction.
By MALEEHA BENGALI
Oct 11, 2021 | 03:13 PM EDT

The generation of traders that run money and man most trading desks in the city today have no experience or would know how to trade inflationary markets. After all, for the past 14 years or so, the Fed has been feeding the deflation narrative to everyone, convincing them that 'buy the dip" is the only way as clearly there can never be any consequences of just pumping too much cash. Even though we have seen consecutive CPI prints of plus 5%-6% year over year, the Fed chooses to stick with their "inflation is transient" narrative.

Transient over three months or one year is an entirely different thing. What choice do they have? After ramping trillions of dollars within a span of a year into markets to jump start the COVID induced recovery, it is no wonder that the demand shock in a short period of time is stress testing supply chains in some key areas of the economy. Some of the bottlenecks can be transient, but there is no doubt that there is a secular pick-up in inflation.

After the higher than expected growth seen earlier this year, GDP growth is slowing down from its lofty levels of 4.5-5% level, to perhaps down to 1.5% even. As the government handouts and stimulus effects are wearing off, producer prices and key consumer goods prices are not really falling. This is known as stagflation, an economic environment where growth is slower and inflation higher, one that usually does not bode well for equities nor bonds. To make matters worse, we now have a new crisis that is unfolding: the global gas crisis!

The thing with commodity markets is that most do not realize that if there is none available in a short window of time, and demand is a necessity, then prices can rally to infinity or to a level where demand is destroyed or supply catches up. This is the thing with commodities like power, gas, electricity - these are essential resources for any residential and commercial business. Over the summer, due to low wind generation, European gas injection season fell short as it preps for winter. This together with a big demand pull for Asian LNG has caused tightness in the system over a very short time period. Strong demand from the UK and EU has caused a further pull that the system cannot handle.

The thing with gas and electricity is that you cannot store it. China has restarted its coal plants and ordering states to produce as much as they can at the cost of climate change. Even Russia claims it can supply Europe with more gas, but that is debatable if that is real or just political posturing to get the Nord Stream 2 pipeline up and running. This "energy crisis" is going to add several hundreds of dollars to consumer utility bills at a time when the job market has not recovered fully and it will add further strain to an already stressed consumer in the U.S. and Europe.

The Brent oil price has rallied recently from a high in the $70s to $84/bbl. It is being quoted as the catch up trade to play post gas/coal price spikes. But one needs to be careful observing all energy markets with the same lens. Brent Oil is seeing tightness for the time being as OPEC+ has very cleverly managed to keep 5-6 mbpd of oil out of the market for an extended period at a time when demand has rebounded. After all it suits their spending plans to see higher fossil fuel revenues and they depend on it. Inventories have fallen back to their five year average, but there is no shortage as such for now. Of course, if travel demand resumes back to normal and the economy is in full swing together with a cold winter, that can change.

What OPEC and markets are not set up for is pure demand destruction. The only way gas or energy prices can come down is if demand slows down or if supply catches up. There is still a month before real winter starts and gas is purely a function of weather models that can turn in a matter of seconds. The heart of winter has not even started and yes, if things get much colder quickly, we can be in a real shortage.

It is wise to chase those commodities that have an actual tightness, but the problem is that most look at demand and project it linearly into the future while keeping supply constant. Supply is the easy one to track, but based on your assumption of the macro economic cycle, your demand can be way off. Are you prepared to take that side of the bet so early on in the winter season?

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At the time of publication, Maleeha Bengali had no position in the securities mentioned.

TAGS: Economy | Investing | Markets | Oil | Stocks | Trading | Energy | Natural Gas |

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