An alternative perspective

11 March 2015

Party Like it's 1999!

“ The only point of economic forecasting is to make astrology look respectable”

JK Galbraith

In the latter half of 2014, Wall Street analysts bent over backwards to prove Galbraith’s adage right when it came to the price of crude oil.

In June, Reuters’ monthly poll of bank analysts forecast Brent crude would average $105 a barrel in 2015.

By October, that had dropped to $94 as the oil price declined. By December, as the decline turned out to be a step off a cliff (see Figure 1), the forecast dropped to $74 – the largest downturn since the depths of 2008. Today, as BP and others talk of the new normal being $50, banks are rushing yet again to forecast into line.

In normal times, this would be seen as positive. Falling oil prices increase real disposable income, lower the cost of production for companies and reduce inflation. People end up with more money in their pockets and demand rises. In short, and pardoning the pun, it fuels growth and boosts GDP, the chief metric by which policymakers live and die.

But these are not normal times. We live in a world of unconventional monetary policy, where economies cluster at the zero interest rate bound and the ‘Big Four’ central banks (the US Federal Reserve, European Central Bank, the Bank of England and the Bank of Japan) have a combined balance sheet of $10 trillion after years of stimulus.

Debt burdens are high. Wage growth is anaemic at best. The concomitant social tensions are evident. And geopolitics is making an unwelcome return to the global stage after the extended ‘entente cordiale’ of the last 25 years.

Indeed, we know we live in strange times when the prospect of lower oil prices has spooked many investors, and when the IMF gladly accepts the fillip provided by oil prices, but still revises global growth downwards. What does this all mean for the year ahead? To answer, we need to unpick this complex picture and understand both the direct impact of recent months and the unintended consequences.

The Barrel Drops

Fundamentally, the decline in oil prices is a net positive. The fall in prices today is due more to a glut of supply and less to a collapse of demand (although this has weakened globally). The reasons are varied, ranging from the pressing need for revenue for the likes of Russia to the worries at OPEC of being supplanted by new sources, such as shale. Both mean no one can afford to slacken on production in the short term, as oil-producing nations seek to maintain market share at all costs.

The hit for exporters is large. Russia and Saudi Arabia, the most prominent examples, produce about seven million barrels of oil a day. Today, this translates to a revenue drop of $420 million a day. They also need fiscal breakeven prices of $105-110 a barrel to balance their budgets. Against a backdrop of increased public sector expenses, ingrained subsidies, fiscal deficits, weakening currencies, rising production costs and sanctions (for some), this is problematic for most oil producers. Those with significant reserves can hunker down and ride out the storm till supply reorients and prices rise. Those without have no easy answers.

But the world thankfully is dominated by oil consumers. For these, such as Europe and Japan, the fall in oil prices is a significant boost to real income.

Elsewhere, in emerging markets, oil consumption makes up 5.4 per cent of GDP in China, for example, and 7.5 per cent in India. Even in the US, where oil consumption is 3.8 per cent of GDP, the shale revolution has only met half of the nation’s energy needs, resulting in net benefits as prices decline.1

This is equivalent to a mammoth fiscal stimulus that will boost world GDP by between 0.3 per cent and 0.7 per cent in 2015, according to the IMF. In hard numbers, 2014 world GDP is $77.6 trillion, making this a global stimulus of somewhere between $230 billion and $540 billion.

That is a massive financial rocket, and therein lies the problem.

Fraternity Parties

The best student parties seem to begin with a barrel. Lots of random unnamed bottles of alcohol (and the occasional mixer) are poured in and mixed together to create a potent cocktail. Everyone imbibes copiously. No one says no. And the rest becomes very hazy. At least, until the punishing hangover the next morning, that is.

Today, we are putting together the fraternity party to end all fraternity parties.

Falling oil prices have a deflationary impact on consumer prices. In normal circumstances, central banks cut interest rates alongside to manage inflation. Today, precious few countries, such as India, can pursue that policy. The rest, particularly the developed world, have a problem. Their rates are already effectively at (and sometimes, below) zero, thanks to the trials and tribulations of recent years.

The situation gets more complicated. With the exception of the US, the rest are struggling to maintain the façade of growth. Japan’s bold ‘Abenomics’ experiment has failed to deliver so far, and Europe is battling the demons of Greece once again. China’s growth is slowing rapidly as its debt burden becomes destabilising, while growth in the other BRICS (Brazil, Russia, India and South Africa) is turning out to be mostly half-baked. Even where quantitative easing has had some success (chiefly, the US and UK), real wages have been stagnant or in decline.

These are not the foundations that policymakers wish for when planning for recovery. Inflation is conspicuously absent, and with it, any realistic prospect of deleveraging in real terms. Even in the US, where growth has been sustained in recent quarters, the Federal Reserve has made it clear it is focused on unemployment reduction and wage growth as key determinants of genuine success. The evidence is not yet forthcoming.

Throw falling oil prices into this disinflationary environment and you ratchet up the stress factor for policymakers. Already, the rapid fall in oil prices has caused inflation to significantly undershoot expectations. Europe tipped into outright deflation in December. Meanwhile, the wider risks to growth mount. Against the stimulus of lower oil prices, the IMF cited lower investment, market volatility, stagnation in Europe and Japan, and geopolitical events as risks that forced them to revise global growth lower by 0.3 per cent.

Alongside – much as ‘good’ deflation from China in recent decades stretched pay-packets further, even as they shrank in real terms – falling oil prices enhance disposable income and dampen the dynamics that might push wages higher. Annual wage growth is likely to continue to disappoint, heaping further pressure on policymakers. The natural reaction for policymakers is to postpone any tightening and reach for further monetary stimulus in an effort to stoke inflation and demand. The amount is simply proportional to their fear of deflation.

Quantitative easing – once unconventional – is now conventional warfare for those at the zero interest rate bound. Japan has renewed its vows of marriage to Abenomics. Mario Draghi has unveiled an ambitious €1.1 trillion programme of bond buying. Even the US is under more pressure now to leave interest rates lower for longer and maintain an accommodative stance. Under these circumstances alone, the balance sheet of the Big  Four will grow by some 25 per cent to nearly $13 trillion by the end of 2017.

This is a huge amount of monetary stimulus on top of the ‘fiscal stimulus’ already provided by falling oil prices.

The real danger, perhaps even likelihood, is one of hyper-stimulus.

The lower quantum of stimulus to date and its distortion of the yield curve have proved powerful steroids to financial markets. Add in more, and you reinforce both the vicious crush for yield that has driven investors (particularly those with liabilities) into every asset class that promises a ghost of a return, and the moral hazard of the policymaker put option.

Meanwhile, the US dollar has strengthened in real terms, partly due to the euro, yen and others engaging aggressively in competitive devaluation. That poses a potential brake on a sustained US recovery, fostering dovishness. It is also a source of stress in emerging markets, given the proliferation of foreign dollar denominated debt in recent years (some 75 per cent of the $2.6 trillion outstanding debt). The resulting tremors will only reinforce the flight of capital to the developed world.

This is a repeat of 1999, but on a wider scale. In other words, an enormous boom beckons across asset classes in 2015. But it will also make it easy to postpone deleveraging, delay much needed structural reforms and enfeeble the economy behind the scenes.

The party is on. How we end and what the morning brings is another matter entirely.

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