Oil, Europe, good and bad & Spain
David R. Kotok
December 29, 2014
Less than two months ago, Oxford Economics modeled sensitivity to the oil price by conducting simulations on 47 countries. Their baseline then was an “$84 Brent crude price average in 2015… gradually recovering to $106 in 2019.” Their updated work has tested further simulations with $70, $60, $50, and $40 per barrel oil against that baseline.
In Europe, they projected “negative inflation,” which is not exactly the same as “deflation,” in the Eurozone. In this instance, however, negative inflation might just as well be deflation, since we are talking about declines in price levels or changes in direction of prices such that they have a downward bias. Of course, the simulations require that the decline in the oil price persist, in order for behavioral changes to occur in these economies.
The simulations attempt to measure the imbalances among countries and how these grow wider (with conditions worsening for some and improving for others) as the oil price sustains a lower level. Impacts on bond yields are projected for these diverse scenarios. The takeaway is how remarkable the disparities among countries become as the oil price falls. For those with falling yields, the levels are extraordinary. For those with rising yields due to credit issues, the mirror image is true.
In Asia, the Philippines is potentially one of the largest beneficiaries of low oil prices. So is Japan. Both are in Cumberland’s international portfolios. Russia, Venezuela and others of similar ilk, as expected, are severely penalized. Cumberland does not own them.
Spain is a big beneficiary in Europe. Out of the 45 countries Oxford considered, at the baseline oil price ($84), Spain is the only country to have negative inflation in 2015. As the price falls, more and more countries make this list. At $40 per barrel, 21 countries (47%) make the list. The leaders are all in Europe and mostly in the Eurozone. In order of impact as measured by negative inflation, they are Spain, Bulgaria, Italy, Poland, Portugal, Sweden, and Switzerland (which is now pegging its currency to the euro). At $60 per barrel for Brent, a majority of the Eurozone countries make the list. At $50 the entirety of the Eurozone does. Remember that “negative inflation” from an external shock acts as a rise in real income for Europeans.
Simply put, low oil prices mean no inflation in the Eurozone, and there is nothing the European Central Bank can do to change that outcome. It also means that the potential for massive quantitative easing by the central bank is growing daily. We expect the ECB to announce large programs and to fulfill their goal of taking their balance sheet above 3 trillion euros. They will find a way to do it by linking the sovereign debt of each country to the creditworthiness of that country so that a combination package pairs debt and credit enhancement. The pairing can be used as collateral in a QE structure. Mario Draghi is about to deliver on his “whatever it takes” promise. We expect this development very soon. Meanwhile, the composition of the ECB Governing Council is about to change. It will become harder and harder for Germany to block a QE program.
Cumberland’s international ETF portfolios favor the use of currency-hedged exposures and include Europe. We do not expect growth to become robust. Euro-sclerosis is still rampant. But conditions will improve over the present recession levels, and the stock markets in Europe are likely to reflect that improvement as the QE unfolds. Michael McNiven, Bill Witherell, and Matt McAleer coordinate the analysis of international economics at Cumberland and incorporate some momentum work to assist in the selection of markets and ETFs. Mike acts as the portfolio manager; Bill does the economic modeling; and Matt’s expertise is with the momentum work. My job is to stir up trouble. DonnaMarie Valles and Maribel Echevarria complete the team, so six pairs of eyes are on the actual trades.
Let me say a word about Spain. First, Cumberland is overweight (120%) against its benchmark. Spain is a small weight, so we can go that high. We use a currency-hedged ETF structure to get to that position. Bill likes the outlook for Spain in economic terms, and Matt supports the decision with his momentum analysis.
A few weeks ago (on December 16), we reproduced an email from a reader in Spain. He was harshly critical of the government and the intrusion that he saw into the Spanish economy. He wrote:
I live in Spain, and it saddens me no end to read what you and others say about Europe and why it isn’t working. You talk of central banks, monetary policy, more or less QE, the Bundesbank, etc., etc. You should live here, and the problems and their solutions are easy and everywhere to see, unless you are a politician or financial expert.
In Spain, I know a father who is a skilled motor mechanic, but he is 66 years old. He son runs a very busy, successful garage, but as a small business he would like a break or a holiday or a little help from time to time, and his father would be ideal. But the police, yes the police, visit this business regularly to check his employment records. If they found his father working even 5 minutes in that business, they would not only fine him but he would lose his pension.
I know a cleaner lady who earns less than 100 euros per week, who took on a little extra work to help her budget “on the black” and was caught and fined 10K euros. Self-employed people have to pay 250 euros a month “tax” every month simply because they are self-employed. That represents for many over 40% of their total earnings. No wonder they don’t work self-employed willingly.I could go on and on and on.
Well, it seems there is another side to the story. A prestigious global economist, who asked to remain anonymous, wrote the response I have reproduced below. On reflection after reading it, I wonder whether Spain might just surprise to the upside.
I found this informative article after reading your letter writer’s venting on self-employment. His 40% simply doesn’t ring true, as that would suggest an income of just 7500 euro a year – well below poverty level, so in Europe you simply wouldn’t work. The 250 euro a month self employment fee is little different than the extra 7.65% a self-employed person in the US pays for FICA – however it is a flat rate as their pensions are defined contribution. It also covers medical, which the US does not.
In the example given in this article, the total effective tax rate is 22% on 30,000 euro (36,000-6000 in expenses). It is 18.6% of the full 36000 euro. This is higher than it would be in the US for a married one child earner at $45,000 (assuming a 1.25 exchange rate). We assume the same 559 euro in straightforward business expenses or $8385 a year. $36,615 would face the FICA @ 15.3% or $5602. Half of that ($2801) is exempt from federal tax. Married couples get a $12,400 standard deduction, plus three exemptions (married one kid) for $12,000. Taxable income is $9,414 at 10% (up to $18150) or $941. This assumes no child care (the kid is 13) or EITC or state taxes (TN or FL not NY or NJ). Total in US would be $6543 ($5602 + $941) or 14.5% (or less) of the full $45,000, a savings of about $1800. They would not have medical coverage – but at that income would qualify for Obamacare, likely with a heavy subsidy.
We thank our good friend (who remains anonymous by request) for making the opposing case.
Now back to a bottom line: 2015 is shaping up to be a challenging year for investors and their advisors. We expect higher volatilities in many markets, surprises from unanticipated corners, and a lot of monetary stimulus in Europe. At the same time, the US will lead the world, and our growth rate now looks likely to be closer to 3.5% for the year. Cheaper oil is a wonderful thing for the winners. The gap between them and the losers will certainly widen.
David R. Kotok, Chairman and Chief Investment Officer