Low oil price to boost stocks, deflation risk: James Saft

[November 25, 2014]  By James Saft

(Reuters) - Lower energy prices should stick around, boosting growth and risky assets like stocks but increasing the risks of deflation.

Oil prices are already down about 30 percent since June, and with little consensus about the likely outcome from a meeting of ministers from the Organization of the Petroleum Exporting Countries meeting on Nov. 27, a snap back seems unlikely and a further trend decline very possible.

This is an unusual oil price fall, and one which is more about a structural change in markets, though it has come along with some weakening in economies in Europe and Asia. The prime and lasting underlying causes are vast new energy supplies coming online in the U.S., notably shale oil, and the fading impact of production disruptions in places like Libya. This implies lower energy prices for a good long while.

“Oil markets have witnessed a structural change,” Michael Haigh, global head of commodities research at Societe Generale, wrote in a note to clients.

“We believe that we’re in the middle of a very fundamental change in the oil markets, the type of change that only happens every decade or two.”

Haigh sees a real possibility, perhaps a 40 percent chance, of oil hitting levels of $70 a barrel for Brent crude and $60 to $65 for U.S. Texas light sweet crude.

In many ways a fall in oil is great medicine for the particular problems in the global economy now. While monetary policy has ballooned the value of stocks and bonds, those who own them are generally already well off and only spend a limited amount of their new wealth.

In contrast, drops in energy prices act as a stimulus by putting money into the pockets of those without large retirement accounts or stock portfolios.

According to SocGen estimates every fall of $20 per barrel in the price of oil boosts global growth by about a quarter of a percentage point in the following year.

All else being equal, a boost in growth should be helpful to riskier assets like stocks.

This is not to entirely set aside concerns that falling energy prices reflect deteriorating economic fundamentals. They in part do, and to the extent that issues in, for example, China, Japan and the euro zone worsen, it is quite possible that we see weak energy prices and falling or volatile global markets.

LOWFLATION AND CENTRAL BANKS

In part predicting the impact of lower energy prices on financial markets is difficult because of the ways in which they might complicate economic management and monetary policy.

With West Texas oil trading at about $76 per barrel, the impact on consumer price inflation in the coming year should be substantial.

“If oil stays at $75 per barrel, which I think it will, CPI should probably go to zero. Zero,” leading bond fund manager Jeffrey Gundlach of DoubleLine Capital said on Monday.

That is a far out-of-consensus view, even if from a leading bond fund manager, but nonetheless the base issue is clear: too little inflation.

For riskier assets, this is a double-edged blade. Inflation has persistently been below the Fed’s 2 percent goal, and with the impact from oil feeding through to core inflation as well, it will be hard for the central bank to raise benchmark U.S. interest rates in the coming year.

Low-priced oil then can extend the bull run, both by improving fundamentals and by extending the period of extraordinary monetary policy.

This is not simply a U.S. issue. While lower taxes on oil in the U.S. make the impact of falling prices on inflation greater there, to the extent that the Bank of Japan or European Central Bank are simply fighting deflationary psychology, it will also prompt easier policy from them as well.

A bit of unexpected support from monetary policy plus an economic stimulus seems like good news for stocks on its face, but this kind of thing is only helpful in limited doses.

Remember the Fed has been using extraordinary tactics for several years, and yet while the job market is doing reasonably well, inflation looks too low for comfort.
 

Investors could easily decide that things globally are starting to look too Japanese for comfort. Anything which brings looser monetary policy is good for markets so long as it doesn’t also undermine faith in monetary policy’s power.

On balance, lower oil prices are a boon, though a boon with small-probability but perhaps high-impact risks.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at [e-mail] and find more columns at http://blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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