David R. Kotok
December 2, 2014
Correction to Oil-Part 1:
Astute readers noted an error in Part 1. The corrected passage should read, “Budgets of many foreign countries are coming under duress. Civil unrest is likely to increase in those countries due to their inability to fund subsidies that have acted to bribe the population.”
The abrupt decline of the oil price has reached levels below the marginal cost of production in most OPEC countries, as well as the US. Over time, low oil prices, if sustained, will slow down the expansion of the US oil sector. There is an intertemporal relationship between these two developments. The oil price goes down now. The impact of a slowing growth rate in the sector occurs in the future. The lags can be months or even years.
In the meantime, the lower oil price has immediate effects on inflation. Oil is pervasive as a commodity, and the fall in price is global; so the rate of inflation around the world attributable to energy cost is falling. Inflation was already low and decreasing.
In some places, lower oil prices will take the inflation rate down by meaningful amounts. In Europe, lower prices will increase the struggle that Europeans have with a zero inflation threshold.
In Japan, low prices will act in a similar but more stimulative way. Michael Drury is the chief economist at McVean Trading and also the incoming chair of the Global Interdependence Center. On November 28 he wrote:
In Japan, which imports energy (all at prices based on crude oil) worth roughly 6% of GDP, the recent sharp price drop could lift real GDP growth by 1.5%–2%! This would largely offset the 3% hike in VAT imposed last year – or justify the second round 2% hike that was just cancelled. The drop in oil prices may save Abe short term, but it will also put at risk both the 3% inflation goal and the need to turn nuclear facilities back on.
In the US the pressure for a rising price level is diminishing every day. The demands for rising labor compensation are also easing since many working households are experiencing an increase in their real income because of a fall in gasoline and related energy prices. Lower energy costs act like a tax cut on American households, and they are getting a big one.
These trends lead to central bank policy-related questions. How can central banks raise interest rates when inflation is ebbing and the most pervasive commodity (oil) is falling in price? How does the Federal Reserve segue to a policy of tightening and raising interest rates when the most substantial growth sector in the US (Energy) is retrenching due to a falling price? As the Fed moves from neutral, post-tapering, to tightening slowly, will the falling energy price cause them to repeat the error of the 1937 Fed hike during the Great Depression?
Because of falling inflation from lower energy prices, we expect the Fed to respond to these developments over time by extending and slowing the rate at which they achieve some normalization of policy. We expect a lower interest-rate environment for a longer period of time. This applies to high-grade bonds, notes, and instruments tied to them. The high-yield bond sector is now bifurcated. Energy-related high-yield debt may come under increasing pressure since it is supported by the energy price level. Non-energy-related high-yield debt may strengthen due to some cost relief for the businesses that benefit from the fall in energy pricing.
The rest of the world faces similar issues. Outside the US, it is responding by easing. The Bank of Japan, European Central Bank, People’s Bank of China, Swiss National Bank, and other central bank policy makers are all moving towards lower interest rates for a longer time. A number of them are seeking ways to expand quantitative easing. Japan has done so in a most dramatic way. The European Central Bank is still struggling with how to do so.
The trend around the world in central banking is lower, longer, near zero, with an extended future of short-term and intermediate interest rates at extraordinarily low levels. It is possible that some of the globe’s interest rates will be near zero or very low for the rest of the decade.
The implications for investors and financial markets are remarkable.
David R. Kotok, Chairman and Chief Investment Officer