Deflation and the falling oil price driving markets
Is the fact that the oil price is taking a dive among rampant global deflation, good or bad news?
September and October 2014 have been very volatile months for equities, in particular with the S&P 500 and the FTSE/JSE All-Share Index down 7% and 8% respectively in September. Both indices recovered by 3% in the beginning of October. The ending of quantitative easing (QE) by the US Federal Reserve (the Fed) has largely been priced in. However, the overriding concern has shifted away from the timing of increasing interest rates in the US (expected mid-2015), to the risk of rising deflation on a global basis, which could cause the global economy to sink back into recession, particularly in Europe. Imara Asset Management believes the European Central Bank has fallen behind the curve and that some form of direct QE is needed to reduce the risk of a recession. Moreover, Germany, which has been the main growth engine in the region, also appears to be slowing down.
Indicative of the concerns around the global recovery is the declining oil price, which could also be the result of issues pertaining to oversupply. Historically, the oil price has been a good indicator of reduced private consumption on the back of weaker economic growth. In early October 2014, Brent Crude dropped from $115 per barrel (p/b) to a very low $84 p/b. This is normally beneficial in a growing economy due to lower input costs and expanding operating margins. In the past, every $10 drop in Crude added about 0.5% to global gross domestic product and it also resulted in a similar drop in interest rates. However, the problem in today’s market is that global growth remains sluggish and consumers are still deleveraging, so the reduced oil price is not filtering through to corporate earnings in a big way, especially in developed markets.
One of the reasons for the declining oil price is that supply has increased since April last year, mainly from non-OPEC (Organisation of the Petroleum Exporting Countries) countries and the US in particular. Advancing technology within the US oil shale projects has seen production costs steadily declining. It is estimated that US producers will remain profitable at levels below $70 p/b and OPEC’s all-in costs will be in the region of $40 p/b. So, in summary, the price of oil is likely to decline even further, which will be extremely positive for sustained low inflation when the global economic recovery gathers pace and there is increased corporate profitability and consumer expenditure.
Today, markets are behaving in an increasingly rational manner, as share prices react negatively to bad economic news, and vice versa towards good news. Whereas before, the main focus pivoted on when there would be an increase in interest rates in the US. Dovish comments by the Fed were usually bullish for equities, despite what was really going on in the economy. Given the growth scenario and deflation risk, there is a real possibility that the Fed will only increase interest rates in 2016 ,due to the fragile recovery. In the event of such an increase, it is expected that equities will most likely decline. However, they should recover rather quickly as increasing interest rates are indicative of better-than-expected economic growth and the resultant higher corporate profits and share prices.
Up until now, the easy money in equities has been made due to excess liquidity in the financial system and the search for yield due to negative real interest rates on interest-bearing instruments. In the short term, bond and equity markets will be dependent on data, with positive shifts made on good economic data and vice versa regarding bad data.
Locally, reported earnings remain very solid and are expected to continue in this fashion due to the positive effect of the weaker rand. About 60% of the FTSE/JSE All-Share Index comprises rand hedges, which makes it a share selector’s market. Value is still being found locally in shares that are exposed to the growing middle classes and urbanisation in Sub-Saharan Africa, India and Asia, such as Sanlam, Discovery, Mr Price, Woolworths and Richemont, to name a few.
Although volatility is expected to continue in the short term, Imara Asset Management sees this weakness, particularly in local shares, as a buying opportunity due to expected good earnings and forward valuations, which are far more reasonable after the recent sell-off.
