‘Shot in the arm’ for oil consuming economies

Positive impact on earnings, and a small positive impact on dividends

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.

INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.

THE VALUE OF INVESTMENTS
AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.

PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.

Do you have a long-term investment strategy?

Keep focused on your end goals and don’t let market noise sway you

The complexity of today’s economic and global conditions, coupled with uncertainty in Europe, North America and China, have combined to create a degree of cautiousness among many investors. A long-term investment strategy could provide you with a clear advantage during uncertain times.

One of the world’s 
richest investors
Warren Buffett is one of the world’s richest people and is a highly successful investor. He’s achieved this partly by identifying companies that he believed were worth more than their market value, investing in them and, crucially, holding that investment for the long term. It sounds remarkably simple, but given the ups and downs of the global markets, it takes a high level of discipline, nerve and conviction in your decisions.

Keep focused on your end goals
It’s important to have in place a sound investment strategy to keep you focused on your end goals and not to let market noise sway you. If appropriate, consider investing at regular intervals over the long term. Keep on investing through market lows when share prices are undervalued, so that you gain more wealth when markets rise again. This can help smooth some of the stock market ups and downs and you avoid investing all of your money when the market is at a peak.

Your attitude towards investment risk
Understand your time horizon and your attitude towards risk. They affect how you invest. We’re all different, and our personal risk attitude can change with our circumstances and age. The nearer you approach retirement, the more cautious you’re likely to become and the keener you’re likely to be to protect the fund you have already built. Note that the value of your fund may fluctuate and you may not get back your original investment.

Spread risk through diversification
Diversify your portfolio so that when one part of the market does not perform it is balanced out by another part of the market that does. View your investment portfolio as a whole. Asset allocation is the process of dividing your investment among different assets, such as cash, bonds, equities (shares in companies) and property. The idea behind allocating your money among different assets is to spread risk through diversification – the concept of not putting all your eggs in one basket.

Assets that behave differently
Balance your portfolio and maintain a sensible balance between different types of investments. To benefit from diversification, you need to invest in assets that behave differently from each other. Each asset type has a relationship with others – some have very little or no relation to each other (known as a ‘low correlation’), whereas others are inversely connected, meaning that they move in opposite ways to each other (called a ‘negative correlation’).

Mirroring the performance of a particular share index
There will always be times when one asset class outperforms another. Generally, cash and bonds provide stability while shares and property provide growth. Funds are either actively managed, where managers make decisions about the investments, or passively managed (typically called a ‘tracker’), where the fund is set up to mirror the performance of a particular share index rather than beat it.

Benefit from compound growth
Think long term. It is time in the market that counts – not timing the market. The longer you are invested in the market, the greater the likelihood of making up for any losses. What’s more, the sooner you start investing, the more you will benefit from compound growth.

Investing as tax-efficiently as possible
Different investments have different tax treatments. Tax is consequential to many wealth management decisions. Our understanding and experience can help you manage and protect your wealth, whatever form it takes. We can advise you about the tax treatment of your current investments, and of any investments you are considering, to ensure that you are investing tax-efficiently. It’s important to remember that your requirements are unique to you. What’s a good investment for one individual is not automatically a good investment choice for you, so don’t follow the latest investment trends unless they fit with your plan.

Past performance is not necessarily a guide to the future. The value of investments and the income from them can fall as well as rise as a result of market and currency fluctuations and you may not get back the amount originally invested. Tax assumptions are subject to statutory change and the value of tax relief (if any) will depend upon your individual circumstances.

Europe’s economic slowdown

Is there room for any further disappointment?

Europe has suffered a stream of destabilising news this year. Firstly, there was January’s emerging markets crisis, which slowed the demand for European exports. Then there were EU parliamentary elections in May, which returned a large number of anti-establishment MEPs to Brussels and spurred David Cameron’s attempt to block the appointment of Jean-Claude Juncker as EU president.

In more recent months investors have also had to contend with fears of a Russian military intervention in Ukraine, tit-for-tat trade sanctions between the EU and Russia, and the bailout of Portugal’s second-largest listed bank, Banco Espírito Santo.

The possibility of deflation
Data that was recently released showed the eurozone’s economy slowing to a standstill in the second quarter of the year, raising more questions about the sustainability of Europe’s recovery and the possibility of deflation[1].

Now, as evidence of slowing growth in the second quarter of the year for a number of eurozone countries has also shown, questions about the sustainability of Europe’s economic recovery and the possibility of deflation intensify.

Extraordinary measures
According to official preliminary data, Italy slipped back into recession in the second quarter of the year, with the economy shrinking by 0.2% after a 0.1% contraction the quarter before[2]. Even Germany, the powerhouse of economic growth up until recently, seems to be suffering, with the economy undergoing a 0.2% contraction last quarter[3].

The danger is that the European Central Bank (ECB) may be missing the big lesson from 1990s Japan – that dallying over economic policy risks a deflationary spiral that’s hard to get out of.
Not that the ECB isn’t trying. In June, eurozone interest rates were cut to a record low, and banks began to be charged for holding cash reserves at the ECB. These extraordinary measures followed hard on the heels of a surprise fall in the annual rate of eurozone inflation to just 0.5% in May[4].

It’s just that the big gun of quantitative easing (QE) shows little sign of being fired yet.
The ECB’s reticence is understandable, even as the evidence of economic fragility piles up. For one thing, QE might be seen – in Germany at least – as providing indebted nations at the periphery with the breathing space necessary to ease up on their attempts to reduce their spending and budget deficits.

For another, the ECB found out two years ago that a pledge to ‘do whatever it takes’ on its own was enough to save the euro. It’s likely too that just the expectation that QE might be used has helped to support bond prices this year.

Devalued currency
Something the ECB ought not to be concerned about is the notion that QE might unleash inflationary pressures and lead to a devalued currency. The US, Japan and the UK, which led the way on QE, have provided practical demonstrations that this need not happen.

If QE is, as some say, the tide that lifts all ships of the financial kind, then European stocks and bonds might benefit from a change of heart at the ECB. In the absence of QE, or presence of only a tiny bit of it, Europe may be set to remain a stock-picker’s zone.

What the ECB must be looking forward to and, perhaps, investors are being asked to also, is some sort of resolution to the crisis in Ukraine and Europe’s economic recovery gathering momentum during the second half of this year.

Bright spots
Certainly, there have been bright spots. Spain’s economy, for example, appears to have been on the mend. The economy there grew by 0.6% in the second quarter, reflecting perhaps a widening gap between countries that have embarked on convincing structural reform programmes and those that have not[5].

However, the International Monetary Fund forecasts economic growth across the region to be ‘a little over 1%’ this year. While that’s an improvement on last year’s contraction of 0.5%, it’s still only about one third of what is expected from the UK and about half the speed at which the US is forecast to grow[6].

To achieve even this, Europe’s economic slowdown last quarter leaves precious little room for further disappointment.

Source:
[1]Eurostat, 14 August 2014
[2]Istat, 6 August 2014
[3]Destatis, Federal Statistical Office, 14 August 2014
[4]Eurostat, Harmonised Index of Consumer Prices, 17 July 2014
[5]Instituto Nacional de Estadística, 30 July 14
[6]International Monetary Fund, July 2014