Navigating the Trifecta

Markets finished out the third quarter of 2023 on a rough note. The first half of the year was marked by a strong bullish impulse in global markets, even through several bank collapses and a near U.S. debt debacle. This bullish sentiment proceeded into July as market participants left worries of recessions behind and revised economic forecasts. However, the end of July through the beginning of October has been a different story for global markets with the main themes being: rising oil prices, rising U.S. interest rates, and the rising U.S. Dollar.

Graph 1: Oil Prices and U.S. 30 Year Interest Rates June-September 2023 (Source: Koyfin)

Graph 2: U.S. Dollar Index June-September 2023 (Source: Koyfin)

This coordinated trifecta has been a powerful force when it arises in global markets and has preceded two of the major recessions in the United States in the last 25 years.

1998-2000

The first of the recessions being the technology bubble bursting and the following recession that lasted through 2003. During this time, the unemployment rate rose from a low of 3.8% to a peak of 6.3%. As Graphs 3 and 4 below show, this driving force mirrors the recent movements in oil, long term interest rates, and the U.S. Dollar almost perfectly.

Graph 3: Oil Prices and U.S. 30 Year Interest Rates 1998-2000 (Source: Koyfin)

Graph 4: U.S. Dollar Index 1998-2000 (Source: Koyfin)

Last Friday’s job numbers posted an unemployment rate of 3.8%, which has risen off the 2023 lows of 3.4%. This is an increase in unemployment, but historically speaking, 3.8% unemployment is still an incredibly strong job market. Time will tell if this rising unemployment trend will continue or if the historically low unemployment rate in the U.S. will persist.

2008

The second recession where we saw interest rates, the U.S. Dollar, and oil prices rise prior to the economic contraction was the great financial crisis. The trifecta started with long-term interest rates climbing in a volatile fashion from 2005 to the middle of 2007. During this time, oil prices slowly climbed and once the market started to realize the implications of the banking crisis unfolding in 2007 and 2008, long-term interest rates dropped precipitously. This coincided with a major rip higher in oil prices and further exasperated the financial crisis. Another important note to take from the below graphs is how oil prices can materially climb in price even in a recession.

Graph 5: Oil Prices and U.S. 30 Year Interest Rates 2005-2008 (Source: Koyfin)

Graph 6: U.S. Dollar Index 2008 (Source: Koyfin)

What Happens Next?

Tetelestai Capital’s portfolio positioning was fully prepared for a recession coming into 2023. This recession forecast was premature and as the markets globally rallied as recession fears fell to zero, I wonder if everyone called off the worse case scenario right as the market headed towards the “worst case” scenario.

Based on the recent Commitment of Traders Report, asset managers are the most long U.S. equity markets they have been since the fall of 2021 when the U.S. equity market was peaking. This bullish sentiment is still very present even with the recent selloff in equities and bonds over the last three months. Volatility remains at historic lows, which keeps volatility targeting funds fully invested as well.

Short-term, equity markets have the ability to trade higher given the oversold conditions present in the market today. However, with cash interest rates yielding more than 5% while current equity market yields (earnings divided by price) in the U.S. are roughly 5.5%, investors are not compensated properly for the additional risk investing in equities. That being said, holding cash and select investments during this time can provide opportunities for exceptional returns if the forces from the oil, interest rate, and U.S. Dollar trifecta continue their dominance.

Don’t fight convexity.

Disclosures: Portfolios I control are long energy related investments.

This post consists of a high level commentary on research conducted by Tetelestai Capital, LLC into economic conditions. Though compelling, your own research should always be done before investing into any security. The risks mentioned in this post are not all encompassing either. This post should not be viewed as investment advice. Tetelestai Capital is not associated with any of the investment companies or products mentioned in this post. If you have any questions about the research Tetelestai Capital conducts, please reach out through the website for more information.