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Oil prices, inflation, deflation and the global economy

Nov 29, 2014

There is such a thing as good and bad inflation, good and bad deflation and how this impacts economies.

OPEC decided not to cut production this week and this has far reaching consequences for the global economy and different countries. China, Japan, India, Europe and the United States are big importers. Cheaper oil and oil derivatives means lower inflation and more money in the pockets of consumers in these countries and one hopes more spending in other parts of the economy. Consumers in counties that produce oil also benefit.

For industry the materials, airlines, consumer sectors all benefit. Miners also benefit because energy costs are a big part of digging and refining metals. Absolute prices of commodities should decline, but profit margins may not. Demand for commodities may rise as economies are given the energy stimulus in addition to cheaper money, because inflation declines everywhere. China and India will cut rates more and more aggressively as both their economies are growing at sub-par rates and inflation is declining rapidly.

Deflation created by lower energy prices is a good thing as it actually drives demand. In this context having a 2% inflation target is perhaps not so sensible. What needs to happen in Japan in particular and many European countries is real rise in wages and changes in demographics. There are exceptions. Spain, Portugal, Greece need structural adjustments. These adjustments can only happen through painful deflation, unless these economies move up the value creating chain. Targeting a 2% inflation rate in Japan, for example, when oil may provide the stimulus and keep prices low does not make sense. Targeting a 2% inflation, plus having the stimulus from energy prices, means that Japan should grow at higher rates. Nikkei at 30,000 is a real possibility. Too much stimulus can be a bad thing though.

If everyone wants to stick to a 2% inflation target, then interest rates will have to remain lower for much longer. This is good for the stock markets and the energy stimulus may actually drive demand enough that stocks don’t become expensive. In any case, stocks may be rising, but JPY, EURO, INR, BRL, RBL etc. have all been falling. In dollar terms the market rallies are not all that impressive. So, is the US market too expensive?

The US has come out of the most serious financial shock to the system since the great crash of 1929. The US stock market has been rising from their lows of 2008, but on a long term basis what is a reasonable rate of return from stocks? Equity risk should be priced at 5-7 percent above the risk free rate. The stock markets certainly have not rewarded the buy and hold investors with anything like these returns. US companies derive a very high percentage of their incomes from global markets, while the domestic economy also makes the US economy a lot more self-reliant compared with any other country or region. Thus US benefits when things are going well at home and better still when things improve with their trading partners.

We live in an age when everyone is looking for ‘bubbles’ everywhere. Is the US stock market forming a bubble? Are bond markets in a bubble? Is real estate in the US or UK in a bubble? The formation of bubbles is complex and for the most part there are signs, particularly in the last stages before a bubble bursts. Correction in the price of assets – stock markets, gold, oil, coffee, currencies etc. can have all kinds of triggers and can become exaggerated through self-feeding mechanisms because (a) there is leverage in the markets (b) geopolitics interferes with rationality and (c) original assumptions supporting prices turn out to be flawed.

Market forces by their design create excesses both on the upside and the downside. The purpose of OPEC is to control supply in relation to demand. If the taps are left open prices will decline because increase in demand will take time. Cheap capital has led to over investment in exploration and production. These excesses need to be corrected. It is a first sign of a painful adjustment.

There is a lot of good news in lower energy prices. Lower interest rates can kick start investments in the emerging economies, where there is a huge need for infrastructure investment. This in turn will support both energy and commodity prices.  Growth in India, China, Brazil, Mexico, South Africa and even Russia will create an enormous consumer class. This growth will also underpin the recovery of Europe and bring untold riches to America.

No one knows if oil price will test $60 or lower. No one knows how the big oil companies will react or adjust to the lower price. No one really knows the impact on their financial health, even for companies which have a large amount of debt. The market is rarely right in its assessment of ‘fair prices’. For most investors it is better to sit it out in times of high volatility. The mix of fundamentals and politics can be potent as illustrated by the recent developments for Russia.

Risks need to be monitored, measured and managed. This is what Algoam’s focuses on to help our clients sail the turbulence of financial markets.

Please contact us for your investment objectives.