Oil, Markets, Volatility
Editor’s note: Originally published on January 6, 2015 Sharply lower oil prices have occasioned a huge discussion about their impact. We see it play out daily in newspapers, on TV and radio, at websites, on blogs, and in market letters. The range of forecasts runs from one extreme to another. On one side, pundits predict a recession resulting from a U.S. energy sector meltdown that leads to credit defaults in energy-related high-yield debt. They predict trouble in those states which have had high growth from the U.S. energy renaissance. These bearish views also note the failures of Russian businesses to pay foreign-denominated debt held by European banks. And they point to sovereign debt risks like Venezuela. These experts then envision the geopolitical risk to extend to cross-border wars and other ugly outcomes. Geopolitical high-oil-price risk has morphed to geopolitical low-oil-price risk. That’s the negative extreme case. The positive forecasts regarding oil are also abundant. American’s Consumer Price Index (CPI) drops robustly due to energy-price ripple effects of $50 oil. We are still in the early stages of seeing these results in U.S. inflation indicators. There is a lot more to come as the lower energy price impacts a broad array of products and service-sector costs. A big change in the U.S. trade balance reflects the reduced imported oil price. We are also seeing that appear in the current account deficit plunge. In fact, both of those formerly strongly negative indicators are reaching new lows. They are the smallest deficits we have seen in 15 years. Action Economics expects that the current account deficit in the first quarter of 2015 will be below $80 billion. That is an incredible number when we think about gross flows history. Remember that the current account deficit is an accounting identity with the capital account surplus. Net $80 billion goes out of the U.S. and turns around and comes back. These are very small numbers in an economy of $18 trillion in size. Think about what it means to have a capital account surplus of $80 billion, driven by a current account deficit of $80 billion. That means that the neutral balancing flows into the United States because of transactional and investment activity are now small. Therefore the momentum of U.S. financial markets is driven by the foreign choices that are directing additional money flows into the U.S. In the end the equations must balance. When there is an imbalance, it affects asset prices. In the present case, those asset prices are denominated in U.S. dollars. They are desired by the rest of the world. They are real estate, bonds, stocks, or any other asset that is priced in dollars and that the world wants to accumulate. In the U.S., where the size of our economy is approaching $18 trillion, the once-feared current account deficit has become a rounding error. How bad can the energy-price hit be to the United States? There are all kinds of estimates. Capital Economics says that the decline in the oil price (they used a $40 price change, from $110 to $70 per barrel) will “reduce overall spending on petroleum-related liquids by non-oil-producing businesses and households by a total of $280 billion per year (from $770 billion to $490 billion).” Note that the present oil price is $20 a barrel lower than their estimated run rate. That is a massive change and very stimulative to the U.S. non-energy sector. The amount involved is more than double the 2% payroll-tax-cut amount of recent years. In fact it adds up to about 3/4 of the revised U.S. federal budget deficit estimate in the fiscal year ending in 2015. Let me repeat. That estimate from Capital Economics is based on an average price of $70 a barrel in the U.S. for all of 2015. The current price of oil is lower. Some forecasts estimate that the oil price is going much lower. We doubt that but the level of the oil price is no longer the key issue. It is the duration of the lower price level that matters. We do not know how long the price will fall, but there is some thought developing that it will hover around $55 to $60 for a while (average for 2015). There is certainly a negative impact to the oil sector. Capital spending slows when the oil price falls. We already see that process unfolding. It is apparent in the anecdotes as a drilling rig gets canceled or postponed, a project gets delayed, or something else goes on hold. How big is the negative number? Capital Economics says, “The impact on the wider economy will be modest. Investment in mining structures is $146 billion, with investment in mining equipment an additional $26 billion. Altogether investment in mining accounts for 7.7% of total business investment, but only 1% of GDP.” At Cumberland we agree. The projections are obvious: energy capital expenditures will decline; the U.S. renaissance in oil will slow, and development and exploration will be curtailed. But the scale of the negative is far outweighed by the scale of the positive. Let’s go farther. Fundstrat Global Advisors, a global advisory source with good data, suggests that lower oil will add about $350 billion in developing-nation purchasing power. That estimate was based on a 28% oil price decline starting with a $110 base. The final number is unknown. But today’s numbers reveal declines of almost 50%. Think about a $350 billion to $500 billion boost to the developing countries in North America, Europe, and Asia. Note these are not emerging-market estimates but developing-country estimates. It seems to us that another focal point is what is happening to the oil-producing countries. In this case Wells Fargo Securities has developed some fiscal breakeven oil prices for countries that are prominent oil producers. Essentially, Kuwait is the only one with a positive fiscal breakeven if the oil price is under $60 per barrel. Let’s take a look at Wells Fargo’s list. The most damaged country in fiscal breakeven is Iran. They need a price well over $100 in order to get to some budgetary stability. Next is Nigeria. Venezuela is next. Under $100 but over $60 are Algeria, Libya, Iraq, Saudi Arabia, and the United Arab Emirates. Let’s think about this oil battle in a geopolitical context. BCA Research defines it as a “regional proxy war.” They identify the antagonists as Saudi Arabia and Iran. It is that simple when it comes to oil. Saudis use oil as a weapon, and they intend to weaken their most significant enemy on the other side of the water in their neighborhood. But the outcome also pressures a bunch of other bad guys, including Russia, to achieve some resolution of the situation in Ukraine. There are victims in the oil patch: energy stocks, exploration and production, and related energy construction and engineering. Anything that is tied to oil price in the energy patch is subject to economic weakness because of the downward price pressure. On the other hand, volumes are enhanced and remain intact. If anything, one can expect consumption to rise because the prices have fallen. Favoring volume-oriented energy consumption investment rather than price-sensitive energy investment is a transition that investing agents need to consider. At Cumberland, we are underweight energy stock ETFs. We sold last autumn and have not bought back. We favor volume oriented exposures, including certain MLPs. We believe that the U.S. economic growth rate is going to improve. In 2015, it will record GDP rate of change levels above 3.5%. Evidence suggests that the U.S. economy will finally resume classic longer term trend rates above 3%. It will do so in the context of very low interest and inflation rates, a gradual but ongoing improvement in labor markets, and the powerful influences of a strengthening U.S. dollar and a tightening U.S. budget deficit. The American fiscal condition is good and improving rapidly. The American monetary condition is stabilizing. The American banking system has already been through a crisis and now seems to be adequately protected and reserved. Our view is bullish for the U.S. economy and stock market. We have held to that position through volatility, and we expect more volatility. When interest rates, growth rates, and trends are normalized, volatilities are normalized. They are now more normal than those that were distorted and dampened by the ongoing zero interest rate policy of the last six years. Volatility restoration is not a negative market item. It is a normalizing item. We may wind up seeing the VIX and the stock market rise at the same time. Volatility is bidirectional. We remain nearly fully invested in our U.S. ETF portfolios. We expect more volatility in conjunction with an upward trend in the U.S. stock market. High volatility means adjustments must be made, and sometimes they require fast action. This positive outlook could change at any time. So Cumberland clients can expect to see changes in their accounts when information and analysis suggest that we move quickly.
