Analysts on every financial news network are screaming about how the lower
oil and gas prices will spur on the U.S. consumer and lead to a stronger economy.
It is true that total retail sales rose 0.7 percent in November, beating analysts'
expectations of 0.4 percent. And the Thomson-Reuters University of Michigan survey
of consumers saw its December 2014 "preliminary index of consumer sentiment" soaring
to 93.8--well above last month's 88.8 reading. Yet, despite this, global markets
are throwing off many deflationary signals that should not be ignored.
The first important market signal is the dramatic decline in oil prices. Since
peaking at just over $100 a barrel this summer, prices
have since fallen by 45 percent. In fact, the last time we have seen a
decline nearing this magnitude was during the financial crisis of 2008. If
this one data point existed in a vacuum, it may be easy enough to attribute
it to just an increase in the oil supply.
If happening in isolation, a surge in the supply of oil would lead to less
spending at the pump and be a boost to the consumer. However, that is not what
is occurring today. First off, years' worth of QE and ZIRP have caused massive
economic imbalances to occur. Capital spending by the energy industry accounted
for 33% of all capital spending in the last few years. States where fracking
is prevalent have accounted for all the job growth in the nation. This would
never be feasible if oil prices weren't drive into bubble territory in the
first place.
After all, the Fed's manipulation of interest rates has left investors chasing
all kinds of yield traps; such as encouraging investments in Master Limited
Partnerships in the oil fracking industry. The cost to extract shale oil and
transport it to a refinery capable of processing it is very high. Therefore,
the price per barrel needs to be higher than $65 per barrel just to approach
feasibility.
Most importantly, although the U.S. has been able to bring more oil on-line,
the rapid decline in oil today has occurred for the same reason it did during
the Great Recession. Namely, deflation and a global economic slump. Most of
the world outside the United States is either in or near a recession. Japan
is now officially in yet another recession. Germany and France have only managed
to narrowly avoid a recession. But Italy has suffered 11 quarters of contraction
in the last 13. In fact, growth is nearly 10% smaller than it was before the
financial crisis began. Europe's southern region is leaving the entire EU (18)
block of nations teetering on recession. Then of course we have the BRIC nations--
Brazil, Russia, India and China, all with economies either in free fall or
decelerating rapidly.
Focusing more specifically on Russia, where the decrease in the price of oil
has left the country in dire straits and the ruble in free fall, investors
have to wonder about the possibility for a debt crisis a la 1998. The Russian
Central Bank was recently forced to raise interest rates by 6.5 percentage
points, to 17 percent. This in an attempt to stabilize the currency. The sharp
decline in the ruble makes international debt payments much more expensive
in ruble terms. A credit crunch is looming in 2015 when Russian companies and
banks are scheduled to repay $120 billion in debt. U.S. banks are far from
immune, having claims totaling $35.2 billion against Russian entities, according
to data from the Bank for International Settlements. Regulatory filings by
the top four U.S. commercial banks show they have around $24 billion in exposure
to the country.
All this is reminiscent of 1998, when Russia defaulted on its debt and created
market dislocations. This lead to the implosion of the hedge fund Long Term
Capital Management, which nearly brought markets to the brink before the Federal
Reserve stepped in and managed a bail out.
Many are taking a Russian default off the table, as they now have a much improved
debt to GDP level. While that may appear to be the case, we should not take
solace in this data point because it is misleading. Russia has supplanted much
of its public debt with quasi-sovereign corporate debt, whose debt levels have
been soaring. The oil-rich nation has seen revenue plummet due to the decreasing
oil price. Add in soaring interest rates and the conclusion is easy to reach
that Russian GDP will shrink; making the debt to GDP figure far less favorable.
But oil is far from the only indicator that is telling a deflationary story.
Industrial commodities are tumbling along with bond yields. In fact, the yield
on the US ten year alone has dropped 27% this year alone. And sovereign debt
yields are at record lows across the planet. Dr. Copper, a barometer for worldwide
economic health, has fallen ill, as prices have dropped 15 percent this year.
In addition, the Baltic Dry Index, a global indicator for the cost to move
goods by sea, is down 63 percent this year. These are not signs of a booming
worldwide economy.
Consumer confidence is indeed at an eight-year high--the highest tally since
January 2007--due to falling oil prices. But polling the consumer in January
of 2007 wouldn't have been a good prognosticator of smooth times ahead. The
truth is that oil prices, industrial metals, bond yields and risk assets in
general are all falling due to a deflationary cycle and global economic duress.
It's amusing to witness nearly every bobble head in the financial media extolling
the virtues of this current collapse in oil prices. WTI crude oil peaked at
$147 per barrel in the summer of 2008; and then the stock market and economy
spiraled into freefall shortly thereafter. Would it have been prudent for market
strategist to claim that the plunge in oil and home prices in 2008 was a harbinger
for a robust consumer to appear in short order? Were these same market gurus
warning investors of a collapse in consumer spending when oil prices soared
from $33 per barrel in the spring of 2009, to over $100 per barrel in July
of this year?
Maybe the U.S. consumer knows something the market indicators don't--and you
can throw the Fed and Wall Street into that mix as well. But more than likely,
economic chaos on a global scale is just around the corner.
