The Power of Lower Oil Prices

The Ten Surprises of 2015 have two prevailing themes. The more dominant is that the decline in the price of oil is generally a positive for the world. It puts money in the pockets of consumers everywhere and it is likely to force Iran and Russia to be more conciliatory in geopolitical negotiations because both countries are suffering not only from the drop in the oil price, but also from the sanctions imposed on them. The second theme is that in spite of notable economic problems in Europe, China and Japan, the United States equity market will have another good year. This is the thirtieth year I have prepared a list of The Ten Surprises to be presented on the first business day of January. The definition of a surprise is an event which the average investor would only assign a one-in-three chance of happening, but which I believe is probable, having a better than 50% chance of taking place. While I usually I get five or six of the Surprises more or less “right,” I don’t create the list to get a high score, but rather to stretch my thinking and that of my readers.

The first Surprise is that the Federal Reserve raises interest rates sooner than expected. Investors are broadly in agreement that the first increase in short-term interest rates will occur around mid-year or later, but I believe we will see the Fed act sooner than that, probably in the first quarter. Many believe this is unlikely because Europe is near or in a recession and Japan is suffering as well. They reason that increased rates will only make the dollar stronger and hurt our trading partners. The lower-than-expected wage increase component of the December employment report is another reason for deferring a rate increase. My view is that the Fed is most responsive to domestic data: the U.S. economy has been growing at 5% real during the last two quarters, unemployment has dropped below 6% and wages are starting to increase. Although inflation is not currently a problem, the increase in rates is likely to be small and more an indication of a change in policy focus than a vigorous attempt to slow down an overheating economy. I believe the dollar will not appreciate much more against the euro and the yen because goods from Europe and Japan are sufficiently competitive at present levels.

The most important part of this Surprise is that the change in Fed policy has little effect on long-term interest rates and the yield curve will flatten. There is so much liquidity throughout the world, seeking some level of safe return, that I don’t expect much of a rise in long-term interest rates. One negative effect of this move is the possibility that it may set off a short-term correction in the equity market. The Fed is no longer pursuing an accommodative monetary policy and the rise in short-term rates may be a cause for one of the inevitable periodic declines we experience every year. It usually takes several rate increases before a significant correction occurs (as set out in Edson Gould’s “three steps and stumble” rule).

Cyber-terrorism has been in the news and the second Surprise is that our luck runs out in protecting our major financial institutions from attack. Our enemies place a high priority on crippling our financial system. Invading the information structure of a major money center bank and forcing it to close for a period of five days, thereby depriving customers of the ability to deposit or withdraw funds, would accomplish that objective. Fear that our banks are vulnerable to cyber-attacks would reverberate throughout the economy. This Surprise is based on the view that the attackers are more able than the cyber-security specialists protecting these institutions. We have already seen the havoc that can be wrought by cyber-attacks with the Sony incident last Thanksgiving. This Surprise suggests more serious trouble lies ahead. There is nothing our enemies want more than to hobble the American economy and this would partly accomplish that goal.

In spite of rising short-term interest rates and cyber-security issues, I still believe 2015 will be a good year for United States equities. This is the third Surprise. I expect reasonable real growth of 3% from the economy in spite of slowdowns elsewhere in the world. Revenues should expand 4% and earnings 8% because of share buybacks, productivity, mergers and acquisitions and other factors. The Standard & Poor’s 500 is selling at less than 16 times the consensus estimate of earnings for 2015 of $125, about the historical average. If the index were to trade at 19 times, well below the bubble range of 25 to 30 times, it would reach the 15% appreciation estimate. That is likely to make it the best-performing equity market among major industrial countries. A strong U.S. economy lies behind the earnings increase; housing and capital spending are expected to be important contributors to 2015 growth.

The European economy is the focus of the fourth Surprise. European Central Bank chief Mario Draghi has been talking about implementing quantitative easing for some time and now he is finally going to do it. The Surprise is that it has little impact and Europe remains on the brink of recession. There is some precedence for this in the U.S. experience. The Federal Reserve expanded its balance sheet from $1 trillion in 2008 to $4 trillion in 2014 and the increase mainly pushed stock prices higher and kept interest rates low. I estimate only 25% of the quantitative easing found its way into the real economy. The recovery took place as a result of natural, not monetary, forces in the business environment. I believe that the slowdown in Germany, resulting partly from diminished Russian trade, will have an impact on the rest of Europe and that the European stock market will be down in 2015.

In the fifth Surprise, I express similar concern about Japan. Shinzo Abe’s first two arrows, fiscal and monetary stimulus, looked like they were working and the country was showing reasonable growth. Most observers were curious to see the impact of the third arrow, structural reform, on the economy. As last year developed, the increase in the sales tax had a greater negative effect than expected and Japan went into a recession in the third quarter. A slowdown in China and other parts of the world also contributed to the weakness. Abe is determined to get the country back on a growth path and is prepared to step up the stimulus to accomplish this. He will suspend the second sales tax increase, which was scheduled for this year, and implement further measures. The Surprise is that it doesn’t work and Japan remains in recession during 2015. The Nikkei 225, not excessively valued, remains flat, but further weakness in the yen causes it to be down in dollars.

China is the subject of the sixth Surprise. Looking at the economic statistics being reported by the country, the official growth rate has been stated at over 7%, but credit expansion of 15%–20% annually is required to achieve it. This amount of credit growth is unsustainable in my view, and the surprise is that China faces up to the fact that growth has slowed and announces it to the world. The new leadership commits to rebalancing the economy toward the consumer and away from investment spending on infrastructure and state-owned enterprises. Recent reports indicate China has been spending heavily on projects like airports, highways, tunnels and rail transport; in a shift, what money is spent on infrastructure goes to air, water and ground pollution control rather than housing and transportation. The objective of rebalancing the economy is proceeding, with significant increases in service sector jobs. These pay less than those in manufacturing plants, so the buying power of those employed is not rising as fast as the number of workers employed. Nevertheless, more people in China are moving from an agricultural to an urban environment for work. While China’s growth rate is slowing, it is still impressive for the world’s second largest economy. It has probably reached the point where the law of large numbers makes faster growth difficult without excessive credit creation. I am not alarmed by the slowdown in China; I believe it was inevitable. I am encouraged by the effort to rebalance. In no case do I expect a housing collapse or a hard landing.

The drop in the price of oil has significant geopolitical as well as economic implications, and this is the subject of the seventh Surprise. I believe the decline in petroleum revenues will deepen Iran’s economic problems. For some time now, the people of Iran have been yearning for the sanctions to be lifted so they can benefit from the economic opportunities available elsewhere in the world. They see little in the nuclear weapons development program that would benefit the average Iranian. Recent comments by leaders in Iran indicate a possible softening of their weapons objective. Lower oil prices make this change even more likely. If Iran would agree to suspend its nuclear weapons effort in some meaningful way, this would be a positive for Middle East stability and the general world order.

The price of Brent slipping into the $40s would also have an important impact on the leadership of Russia. This is the eighth Surprise. The economy there was suffering even before the sanctions were imposed and the price of oil collapsed. Conditions have worsened since then. The country is running out of foreign exchange reserves and a crisis may be approaching. Some believe China may offer a bailout plan involving a prepayment for oil and gas deliveries, augmenting agreements already in place. I am skeptical. Russia’s leader, Vladimir Putin, has said that his people can endure temporary hardship.

I believe the situation is serious, the people are losing confidence in Putin, and he may become more willing to compromise on his territorial expansion plans and recognize the independence of Ukraine with a promise of some autonomy for Eastern Ukraine. If he agreed to comply with a twelve point program proposed four months ago, the sanctions could be lifted. At some point, Putin in his desperation complies, but he is humiliated in the process and resigns. Ruling Russia has proven to be exasperating for him and he decides to seek a less pressured life. Later on in the year, as demand from the developing world improves, the price of oil begins a steady climb back toward $70 for Brent. I believe the sharp decline in oil prices has excessively upset the high yield market. Energy securities account for almost 20% of high yield and their decline has had an impact on everything in this asset class, creating a buying opportunity. The buying opportunity in energy securities is the ninth Surprise.

In the tenth and final Surprise I argue that the Republicans will try to position themselves as the party that rises above internal dissension so that it can get constructive legislation passed in Washington. I cite as examples the Keystone pipeline, the tax code and immigration. Obama has threatened to veto the pipeline and many think the pipeline is not necessary with oil prices low. Others believe the project will not create many jobs and is harmful to the environment. Many Republicans don’t want to support any of the various forms at tax reform other than reducing corporate taxes. Even more do not want to relax any aspect of immigration that provides relief to illegal entrants, even if they have children born here. Right after last November’s election, it looked like the Republicans’ primary objective was to repeal the Affordable Care Act. They now realize that might be futile and it would be better to prove to the American people that Republicans can improve life for them. They only lost the presidency by four points in 2012. If they could capture some portion of the Hispanic vote, which overwhelmingly supported Obama, their chance for victory would improve. Jeb Bush could help them accomplish this and he is likely to be the candidate.

In the period since the Surprises were announced, I have gotten some criticism that they were not bold enough. A few even believe several were consensus views and not at all surprises. There were those who thought the Fed would raise rates, but most thought it would be later in the year, not earlier as I believed. Many thought the market would rise, but not as much as 15%. Europe’s recession was expected, but few thought Mario Draghi’s stimulus would have little effect. Few thought China would admit to growing at less than 7%, although many saw the economy there softening. Most believe Shinzo Abe would get Japan’s economy growing again. Few thought Iran would negotiate a pullback from its nuclear development program or that Russia would recognize Ukraine’s independence and Putin would resign. A major money center bank closing because of cyber terrorism wasn’t on anyone’s list and the Republicans working together to get something done was given a low probability. So I believe the Surprises fulfilled their mind-stretching objective.

This year I have four Also Rans, which I didn’t believe had more than a 50% chance of happening or I did not think were as important as the ten I picked. The first one is that water becomes the focus of environmentalists, moving air pollution to second place. Large parts of the United States experience droughts, diminishing agricultural production. In China and India literally hundreds of millions of people are without safe drinking water, making them susceptible to disease. Conflict over water rights becomes an important political issue in Asia.

The second Also Ran involves Internet commerce. Commercial hotels and conventional taxi services didn’t complain about Airbnb and Uber when they were minor business irritants, but now that they are big global operations, pressure is increasing to make sure that each establishment and vehicle has the proper insurance and pays the appropriate fees and taxes. Making independent participants comply is difficult and this sector of stocks suffers a sharp correction.

In the third Also Ran, Brazil has a comeback. Dilma Rouseff becomes pro-business in order to improve the country’s growth and moves away from her socialist policies. The country has vast natural resources and a growing middle class, giving it considerable potential. Investors start accumulating Brazilian equities again.

Finally, in the last of the Also Rans, I suggest that Hillary Clinton, the Democratic frontrunner candidate for President in 2016, bows out of the race. She very much wants to be the first woman to hold office, but she doesn’t want to lose. If Jeb Bush were the Republican candidate and attracts a reasonable number of Hispanic voters, and some liberals who are suspicious of Clinton’s ties to Wall Street and Hollywood don’t vote, the race could be very close. If she runs and wins, the difficulty of getting important legislation passed in a Republican Congress could also be exasperating and discourage her further. This combination of factors may cause her to withdraw, throwing the Democrats into frenetic confusion.

Now let’s see how the year turns out.


(c) Blackstone


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