Despite the so far rather negative response of equity markets, the oil price falls could be seen as a ‘shot in the arm’ for oil consuming economies, with many viewing the oil price decline as being deeply beneficial because it amounts to a reduction in input costs and a dividend to consumers.
However, it’s not all good news, as this could result in increased volatility and geopolitical risk. The polarisation of performance between markets which are net importers of oil and those which are net exporters is likely to continue.
Positive impact on earnings
The decline in oil price is expected to have a positive impact on earnings, and a small positive impact on dividends. Global growth will be given a boost, inflation will be pushed lower and central bank policy may well remain more accommodative, with rate rise expectations getting pushed out even further in the near term. The reach for yield may extend further and, with oil related shares being amongst the higher yielders, but increasingly risky, other areas with yield may be bid up even further from current levels. The starting point is different, but it is worth remembering that the last two supply-led oil shocks, in 1987 and 1999, were followed by equity bubbles.
Contagion from the high yield market
However, based on historical experience, global energy earnings are set to decline by around a quarter to a third, and equity markets are hardly enthusiastic about the decline in the oil price seen so far. Firstly, markets are concerned that, with inflation low, the oil shock may tip economies into outright deflation with negative implications for consumption. Secondly, capital expenditure may be at risk in this scenario and has also been heavily boosted in the US by the shale story, which is at serious risk from here. Thirdly, the labour market in the US, which has been very strong, has been significantly boosted by the shale states. If this is derailed, then perhaps US growth is at risk. Another risk is contagion from the high yield market where energy issuance has been high.
Negative reactions have focused on three themes:
1. That the speed of the fall creates a major shock for the oil producers, who will be forced to cut investment rapidly.
2. That falling world demand is the possible cause, so we should be worrying about recession; increasing (shale) oil production has contributed more to the oversupply, even though demand has grown by less than forecast, so the lower price does not seem to be a forecast of recession as it was in 2008.
3. That lower oil prices will push inflation rates lower or into negative territory, increasing worries about deflation. Lower inflation due to falling costs rather than collapsing growth could be seen as ‘good deflation’. Reversing the argument, would higher oil prices accompanied by higher inflation rates really be better?
Reduction in unavoidable spending
Relative to where we were a few months ago, the growth outlook has improved as a result of the halving in the oil price despite the equity markets’ grudging reaction to the windfall. The fall in oil prices is a major benefit for much of Asia (including Japan), which is a big importer of oil. Another key beneficiary is consumer spending beneficiaries in developed economies, where the reduction in unavoidable, spending on fuel and energy will free up income for other uses.
Sectors which are highly energy intensive (such as cement or mining) and where hydrocarbon operating costs are significant (for example, autos, trucks and transportation companies) should enjoy some margin relief from such a large fall in prices, although it may take some months before analysts’ earnings estimates fully adjust. Selectivity is important, since other factors impinge on the different sectors and the world remains in a subdued growth phase that will not float all boats.
Overall, the impact of the lower oil price is beneficial. Consumers and companies the world over get cheaper transport, power, raw materials and heating. Countries that import oil have a huge benefit to their terms of trade, and also a fiscal benefit if they are subsidising oil prices to the consumer. But it’s not all good news, as this could result in increased volatility and geopolitical risk. The polarisation of performance between markets which are net importers of oil and those which are net exporters is likely to continue. There is a real need not to generalise about global emerging markets but to distinguish between good ones and less good ones.
Volatility in asset prices
The fall in the oil price recently has caused a lot of volatility in asset prices, but its impact on demand will be deeply beneficial because it amounts to a reduction in input costs and a dividend to consumers. We have seen that the headline rate of European inflation has dipped into negative territory, but this is not the type of pernicious deflation that destroys confidence and encourages consumers to defer purchases; rather, it alleviates pressure on real incomes.
Falling oil prices help airlines and distribution companies by lowering input costs. They help automotives who benefit from the marginally lower cost of buying a car and cheaper fuel; they benefit a wide variety of consumer sectors such as retail that will see higher demand from consumers enjoying higher real incomes. It is true that the energy sector, including those companies who supply energy giants with capital equipment, will struggle. Certain countries such as Norway will also be negatively affected, but on balance this is a shot in the arm for the European economy which will help to heal confidence.
While there are obvious losers from the fall in oil prices, there are also winners. Many emerging markets, such as India, have limited natural resources and import oil, so will enjoy an immediate benefit to consumer incomes and balance of payments. Consumers in Western economies are also clear winners, with the benefit of the oil price fall being estimated as equivalent to a $200bn tax cut for US consumers.
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