2015: How low can it go?

Financial markets have endured a fair degree of turbulence in the last 6 months and made a faltering start to the new calendar year. Is this a sign of an imminent collapse or will markets recover to post further gains in 2015? Key determinants will be falling oil prices and the impact of monetary policy in the big four economies: the US, EU, China and Japan.

Crude Oil

Crude oil is plunging towards its 2008 low of $30 per barrel. Supply is inelastic, with the Saudis refusing to play their normal role as swing producer and cut production to stabilize prices. Demand will take time to recover despite the massive stimulus effect of low oil prices to the global economy. If current supply levels continue, the 2008 bottom is under threat.

Nymex WTI Light Crude

More likely than a cut in demand, is a threat to supply, with political turmoil erupting in one or more of the countries reliant on oil revenue: Russia, Iran, Venezuela, Nigeria, Iraq, Libya and other vulnerable states. Political turmoil could be a reaction to food scarcity and rising prices, as Venezuelans are already experiencing, or it could be fomented by one/more vulnerable producers seeking to throttle supply and drive up prices. Apart from domestic instability, sovereign default by Russia, while still unlikely, could also unsettle financial markets.

How will falling oil prices affect the global economy?

Energy stocks are falling, increasing downward pressure on broad market indices.

DJUS Oil & Gas

Inflation expectations are falling, with the spread between 5-year Treasury yields and the equivalent inflation-adjusted TIPS well below the Fed’s 2 percent inflation target.

Inflation Breakeven

Will falling oil prices increase the risk of deflation, as suggested by some pundits? Highly unlikely. Falling prices may shift consumer spending patterns, with consumers spending the savings from lower energy prices on other discretionary items. But this is likely to boost confidence and encourage further spending, rather than cause a contraction of total spending.

Falling prices caused by a contraction in total spending, as in 2008/2009, are an entirely different matter. Consumers increased savings and repaid debt in response to rising uncertainty. Prices fell in response to the resulting contraction in spending. Shrinking aggregate demand impacted on incomes, causing further cuts in spending and a self-reinforcing, deflationary spiral which caused serious damage to the economy despite the Fed’s best efforts.

Current price falls are driven by increasing supply, while a deflationary spiral is caused by contracting aggregate demand. Lower oil prices will act as a huge stimulus for the global economy towards the second half of the year and are likely to lift growth rates.

US stocks

Low inflation is likely to ease pressure on the Fed to lift interest rates. The S&P 500 continues in a bull-trend, with 13-week Twiggs Money Flow trending above zero, indicating long-term buying pressure. Respect of support at 2000 would suggest another advance and breakout above 2100 would confirm.

S&P 500

* Target calculation: 2000 + ( 2000 – 1800 ) = 2200

Rising troughs on CBOE Volatility Index (VIX) indicate a shift from low to moderate risk, but there is no cause for concern unless we see activity ranging between 20 and 30.

S&P 500 VIX

Europe

The graph below compares the annual rate of change in total assets of the European Central Bank (ECB) to the Fed. Fed assets are stated net of excess reserve deposits which pay interest to depositing banks, something not offered by the ECB. Both the Fed and ECB rapidly expanded their balance sheets in 2008 in response to the global financial crisis, while the ECB had to repeat the process in 2011/2012 to address the PIIGS sovereign debt crisis. The ECB’s mistake was allowing their balance sheet to shrink in 2013, in response to pressure from some members (primarily Germany) to return to austerity. The Fed was far more wary of aftershocks and maintained an expansionary policy throughout this period. The US economy strengthened as a result, while the EU contracted and threatens a deflationary spiral if the ECB does not alter course.

ECB compared to Fed Total Assets ROC

Dow Jones Euro Stoxx 50 proved surprisingly resilient in the circumstances, breaking above 3000. Expect further consolidation between 3000 and 3300 until we get a clear direction from the ECB. Declining 13-Week Twiggs Momentum is typical of a long-term consolidation. But reversal below 3000 would warn of a contraction.

Dow Jones Euro Stoxx 50

China

The PBOC is also adopting expansionary monetary policy in response to declining activity and a weakening Yen (which erodes China’s export advantage). The Shanghai Composite Index surged, with 13-week Twiggs Money Flow indicating strong buying pressure. Breakout above 3400/3500 would suggest another up-trend.

Shanghai Composite

Japan

We have a similar situation in Japan, with the BOJ expanding on a massive scale, driving stocks higher and the Yen lower. The Nikkei 225 found resistance at its 2007 high of 18000, but Twiggs Money Flow appears strong and the index is likely to respect support at 16000.

Nikkei 225 Index

Aggressive monetary policy adopted by the two central banks is high risk and could end in tears. Especially if the two start to compete in currency markets for an export advantage.

Australia

The RBA is far more conservative and likely to rely on falling commodity prices to weaken the Australian Dollar. Further interest rate cuts seem unlikely given the current scenario. The ASX 200 has not made any progress since July last year, but rising troughs on 13-week Twiggs Money Flow indicate healthy support at 5000. Breakout above 5500 is unlikely at present, but would suggest another advance.

ASX 200

Low iron ore, coal and LNG gas prices are likely to inhibit the Australian recovery. What is needed is a strong program of infrastructure investment to restore confidence. This seems to be slow in getting off the ground. What is important is investment in productive assets, that produce market related returns on investment, rather than social infrastructure. The acid test is whether the completed assets can be sold to recoup money invested, providing funding for further infrastructure assets or to repay debt.

The only value of stock forecasters is to make fortune-tellers look good.
~ Warren Buffett