The temptation when giving opinions on topics that have already been very widely commented on is to try and offer a surprising new perspective. We are supposed to find an angle no-one else has considered and present a conclusion so elaborate only expert insight and complex analysis could have come up with it. Well, this time, I’m happy to state the obvious. What is obvious to me at the moment is that the halving of the oil price is the best piece of news the global economy has received in a long time.
Isn’t it more complicated than that? Not really. It is true that it’s not going to be a celebrated development in every regional economy. For certain concentrated areas – the oil producing Russias and Norways for example – it’s definitely bad news. And even in the rest of the (commodity consuming) world, the effects will take a while to feed through to broader economic conditions. Furthermore, there are a lot of other factors present in the world today that present genuine risks and which could cause a lot of volatility in data, sentiment and markets, over the period of time it takes for the positive effects of dramatically cheaper commodity prices to play out.
But in my view, there should be no doubt that at an aggregate global level, a massive tax cut has just been delivered to businesses and consumers – in terms of lower costs and higher purchasing power across the board, not just on oil as an industrial input or on filling up at the pump. It would take a great deal of negative developments to offset this, and there really hasn’t been anything in the medium-term fundamental evidence to suggest that we should be expecting things to go so badly wrong. So I believe it is just a matter of time and, ultimately, the result will be quite straightforward, even if the journey is not.
Cheap oil can succeed where policy-makers might have failed
So if it is so obvious that global growth prospects have been given a massive shot in the arm, why do we still have falling (and in some cases negative) mainstream government bond yields and elevated risk premiums on equities?
The IMF’s recent lowering of its forecast for global economic growth for this year and next points to something that has been quite noticeable in recent months – a significant shift in beliefs. The world’s major problem today seems to be that people still don’t believe in genuine, sustainable growth. What’s more is that they also seem to have lost faith in the willingness or ability of politicians and central bankers to do anything about it. There appears to be an increasing perception that policy-makers have failed to act quickly or aggressively enough, and that the transmission mechanism between monetary stimulus and the real economy has failed. This is a particularly common view in areas like the Eurozone, which have seen a second-wave financial crisis in the years since 2008, rather than the more straight-line recovery of places like the US.
Perhaps this perception is accurate, after all, central banks have found the scope of factors they are supposed be able to control vastly increase since the global financial crisis. It is perfectly plausible they have not been able step-up to the plate. Maybe the transmission mechanism has not functioned as hoped, in terms of banks not using extra liquidity to lend more to businesses and consumers. Or perhaps the markets are just being impatient. Basic economics tells us we should expect a lag between policy action and real economic effects. Either way, the collapse in the oil price could quite easily achieve exactly what policy-makers have been attempting all along –increasing economic optimism by putting more money in people’s pockets to spend and invest. The transition mechanism in this case is significantly more straightforward, although we should still expect a lag in terms of results, as has been the case on previous occasions where economic growth has lagged an oil price collapse (see example for late 1980s, chart below).
Patience and perspective
The issue at the moment is a degree of myopia about this lag. What market participants have experienced so far is a hugely material price adjustment in a significant financial market. It was a shock, and the initial response was fear about potential broader instability. The speed and magnitude of the decline in the oil price heaped further confusion on already fragile sentiment. As a result, in recent weeks we have seen short-term phases in which the market seemed to be irrationally deciding that a lower oil price is good for government bonds and bad for equities.
There does not seem to be clear justification – in terms of anything we have observed in the macroeconomic data in recent months – for the view that the weaker oil price is reflecting weaker growth. Yet, the view of the IMF (among others) seems to be that weaker investment, on the back of businesses’ weaker growth expectations, will more than offset the positive effects of significantly cheaper oil. Again, the evidence just doesn’t support this. Indicators on consumer confidence are looking increasingly positive. For example, a recent reading for the US NFIB Small Business Optimism indicator showed that US small businesses are now as optimistic as they were in 2000 – that’s pretty optimistic.
The bearish argument about the oil price is that direct credit problems within the oil and gas sector will cause an instant collapse in investment in that sector, and then contagion into other sectors. If we look at credit pricing over the past 12 months, we can see that while spreads have widened modestly across most sectors, the blow out in spreads in the energy sector is a very different story.
The reality is that most things that are not directly related to the energy sector have actually not moved very much. So there has been no evidence that the market is worried about contagion. Rather, it seems to me that downgrades to global growth forecasts are reflective of broader risk aversion – this shift in sentiment that had begun before the oil price became the headline everyone was attributing equity market volatility too. If you look at the lack of correlation in the longer-term between the oil price and equity indices in places like China and Germany, where there little oil exposure, you can’t say this is a concern about the global economy.
I think the response we are seeing from more bearish commentators is a reflection of the persistence of the trauma of 2008 in investors’ minds. It is the role of memory and the power of association that is making people fearful. The lesson learned from 2008 is that illiquidity is a risk. So when we observe equity markets gapping down in an irrational manner, what we are seeing is panic and the demand for higher risk premia for perceived illiquidity. Investors will impulse-sell whatever they can in response to a shock like the oil price halving in a matter of months, forgetting about everything other than a now deep-seated fear of illiquidity. This sort of response is not a considered judgement about what the oil price collapse ultimately means. Rather, people’s view on the subject is being polluted by a broader air of pessimism that has been fuelled by a lot of noise last year on all kinds of short-term factors. For me, the idea that something like slightly weaker economic data for Japan is more meaningful in terms of the medium-term global economic outlook than a 50% cut in the oil price makes no sense at all. What is always interesting is how investors’ behavioural response to developments will vary according to the timing of when they observe certain factors.
So it is very difficult to argue rationally that the collapse in the oil price is anything but good news at the aggregate level. The evidence suggests the real problem the global economy faces today is not aborted growth, but a lack of optimism to drive businesses and consumers to spend and invest. Policy-makers have so far failed to overcome this. A massive decline in the oil price could end up doing all the work for them. But it will take time for the real effects to be felt, and during that time there are other things that will likely contribute significant volatility to markets as investors continue to struggle to shake-off the shadow of 2008. We have to expect that an interest rate rise from somewhere like the US will cause a lot of turbulence across financial markets initially, even though this too would be reflective of an improvement, rather than deterioration, in economic conditions. It is possible that the decline in the oil price will reduce the need to raise rates by keeping inflationary pressures low. But it should actually make a rate rise more likely because it is the best chance the global economy has had in years to deliver a positive growth surprise.
My expectation is that if growth does surprise on the upside, the medium-term outlook for equities is positive, but with a high degree of choppiness. Equity investors should be encouraged by a halving of the oil price, if they are patient and extend their time horizons to allow for a lag in the positive effects to feed through. That said, equity selection is very important. I would be very cautious about taking on assets that are directly related to commodities at the moment. We have to be careful about the scope of odds of where commodity prices will go next. We cannot lazily assume that prices are going back to some previous level. One thing that has become increasingly clear in recent years is that we need to be cautious on the idea that some kind of equilibrium level exists for all kinds of things. The possible range of outcomes on most things today means there is not much about financial markets and the economic outlook that is straightforward. Except that cheap oil is good for growth.