The Falling Oil Price – mirror on China, geopolitical football or beacon of hope?

The oil price has fallen from $128 on March 1 to below $90 in recent days, but this sharp decline has received little news coverage.  There are good reasons from both supply and demand perspectives why this 30% fall has occurred:

On the demand side

  • Economic data since March have disappointed expectations, following a burst of optimism in January and February on the back of the ECB’s dramatic action to offer a trillion Euros of extra 3-year liquidity at the start of the year. However none of this liquidity made it into the real Eurozone economy – it went into the banking system and the banks used it to support the government bond markets in Spain and Italy as many other investors used the opportunity to exit from their Euro assets.
  • Austerity continues to drive the peripheral countries deeper into recession and the German economy has seen its export engine struggle as the rest of the world slows down.
  • In the US, the improvement in the labour markets that appeared to be taking place at the start of the year has stalled as austerity from the individual states, which are forced to run balanced budgets, has reduced domestic demand. Growth expectations for 2012 have been steadily reduced over the course of this year.
  • It is however the Chinese economy which is the key driver of oil demand, and although not clearly reflected in the official statistics, which are aggregated from local regions all keen to show themselves in a good light to the centre, there is increasing anecdotal evidence of a major slowdown in demand from manufacturing companies for raw materials with the appearance of large inventories of coal and copper within China, together with continued weakness in demand for electricity.

On the supply side:

  • Saudi Arabia has pumping record amounts of oil over the last three months and shown no sign of reducing this rate of production as the oil price has fallen  close to levels (generally assumed to be $80-90 per barrel), which make it difficult for them to balance their budget. They have declared this to be part of a policy aimed at helping the Western economies – closer to the truth might be that the American authorities have requested a much lower oil price, which would boost consumer disposable income and confidence and thus give more room for the Federal Reserve to ease policy and for Obama to win the election in November.
  • Oil production and exports from both Iraq and Libya have been expanding rapidly this year as calm has returned to these countries and with it a focus on rebuilding export earnings.

So weaker demand and increased supply have occurred together and prices have fallen sharply. For Western economies trying to deal with the after–effects of a major banking crisis, this is positive news.  Lower petrol prices leaves more money in consumer pockets to spend in other areas of the economy, at a time when consumer incomes are otherwise under pressure, and allows the Central Banks to be more relaxed about any inflationary pressures. Should Europe be able to find a way through its problems in the next few weeks, there may be scope for an equity market rally.

In the longer term, it should be noted that the USA is moving aggressively towards being energy self-sufficient). The new fracking technologies are significantly increasing the productive potential of its own gas reserves, which will, over the long term, ensure that it will not be dependent upon the Middle East for its energy requirements. Structurally this bodes well for the US relative to Europe and Japan, which will remain more beholden to political developments in those regions, and therefore for the dollar relative to the euro and the yen.

UK Economic Policy – Sticking to Plan A (plus a bit)

Last week as investors worried about the Greek elections, the Spanish bank bailout and the Federal Reserve meeting, George Osborne and Mervyn King made significant announcements about UK economic policy. Since coming to power, the UK’s approach to managing the economy can be described as a slow but steady tightening of fiscal policy over the medium term, to avoid an austerity-driven recession as seen in parts of Europe, combined with an extremely easy monetary policy.

The complicating factor to this logical response to the UK’s problems was capital requirements that had been placed on UK banks following the banking crisis – much more exacting prudential requirements with regard both to capital and to liquidity risks had forced the banks into buying large amounts of gilts (UK government bonds). Whilst one side of this coin meant that banks’ balance sheets were better protected, the other side of that coin is a reduced emphasis on the attractions of lending to small and medium sized businesses, which is a vital but nonetheless risky activity for banks.

Mr. Osborne announced a scheme to offer both government guarantees and cheap funding for banks that lend to the domestic personal and small business sectors – at £80bn this is approximately 5% of total existing lending to these sectors. Mr. King announced that going forward banks would not have to hold such large amounts of liquid gilts on their balance sheets, and thus would be able to make more loans (which are less-liquid assets) to business. There are few details yet but assessments of how much this might mean are around £150bn.

These announcements are clearly aimed at allowing the QE policy to work more effectively, which until now has worked to inject lots of money into the financial system. However, little of it has found its way into the real economy – thus financial asset prices (in particular the price of gilts) have been supported but with only a small impact on growth. The banks are receiving very strong guidance that they should be lending.

There remain though both demand and supply problems with this new approach, which are likely to mean that it will have only limited success. First, with regard to the demand for bank loans, the banks consistently report subdued demand to borrow. Certainly the housing market is slow (apart from Central London, which is beset with Greek, Russian and Middle Eastern investors seeking a safe home for part of their wealth) – falling house prices is not an incentive to borrow heavily and a lack of confidence in employment prospects or future pay increases is endemic. Similarly the subdued state of demand that many small businesses face will mean that very few are seeking to borrow to expand. Where there is demand to borrow from small businesses, it is usually to cover slow trading (or poorer credit risks). On the supply side, the credit boom conditions of 2002-2007 is now over and banks are not prepared to lend on the optimism-fuelled terms that were available then. Instead, they are reverting to lending terms similar to those on before 2002, which feel now much more restrictive to businesses.

Osborne and King are sticking with Plan A, but trying to make sure more liquidity gets into the real economy. It will help at the margin to boost private sector growth as the public sector continues to be cut back, but the general desire of most people and companies is to reduce their debt rather than increase it. This combined with the major uncertainties within the European economies, will prevent a rapid recovery. There are risks to gilt prices since the banks are being told that they do not need to own so many gilts, but the prospects for UK equity prices are positive given their very low valuations and the (minor) benefits to growth of this adjustment in policy.

Situation Vacant – one new genius economist

There is an old joke that if you laid down all the economists in the world from end to end, you still wouldn’t reach a conclusion. It is certainly a tragedy that as the western world finds itself in the biggest economic mess since the 1930s, the economics profession is unable to articulate clear policies to resolve the problems.

Up until the 1930s, politicians did not see themselves as particularly responsible for the economy. The government’s finances were managed in the same way as any other family unit, in that you made sure that spending did not exceed income, and borrowing was only acceptable to cover the cost of emergencies like wars. Foreign exchange rates were all fixed by adherence to the gold standard and it was considered a shameful act to devalue.

This went wrong in the 1930s when the 1920s financial boom led to a banking crisis the following decade. As the banking system sought to deleverage its balance sheet, asset prices fell and unemployment soared. Wages fell but economic recovery did not come because the economy was in a Depression and companies and individuals did not have the confidence to spend. It took the economic genius, John Maynard Keynes to show how capitalism could get stuck in this Depression mindset with low growth and low interest rates. His solution was that governments should take advantage of their high credit status to borrow the excess savings that were being created by the lack of confidence and go out and spend them to kick-start an economic recovery. He always expected however that once recovery had returned, then governments would seek to run budget surpluses so that the extra borrowing was repaid and hence temporary.

Post-war politicians however focussed on the ideas that (i) budget deficits were now good for the economy and (ii) they had the power to manage the economy to deliver full employment, and ignored the idea of running budget surpluses in the good times to offset the deficits that should be run when bad times hit. As the decades wore on, the politicians promised their people more goodies from public spending, budgets only got balanced in economic boom conditions and the size of the governments’ debts relative to the size of their economies rose steadily.

Recent academic work (Rheinhart & Rogoff) has shown that as the Debt to GDP ratio nears 90%, the capacity for economic growth diminishes markedly. The Western world is at or past these limits and finds itself there just as the next 1930s style banking crisis has hit it. The standard Keynesian response of government borrowing and spending is now either not available since markets are unwilling to lend to some governments because they have lost their strong credit status, or not palatable since it is likely to damage longer term economic growth prospects.

In general the right-of-centre politicians (Merkel, Cameron, Romney) stress the need to get government deficits and debt under control, so as to retain the long term confidence of financial markets. This austerity agenda does nothing for short term economic relief however. The left-of-centre politicians (Hollande, Milliband, Obama) stress the standard, Keynesian policies of spending in the short term to enable recovery to occur. The problem here is that financial markets might only provide the funds at an unacceptably high interest rate, and trigger a wider debt crisis.

The positions of both sides contain important truths, but the arguments display the divisions between economists. Japan, over the last 20 years, can be used as an example to prove each is wrong. The Keynesian response of government borrowing and spending has not led to sustainable economic recovery but has led to a Debt to GDP ratio now of over 200%. However this massive debt burden has also not led to a financial market crisis (yet), as Japanese savers have been happy to lend to their government for miniscule returns.

A Nobel Prize, a place in history and the gratitude of the world surely await the economist who can untangle all this and provide the solution to our current problems.

Paying for the privilege of lending

Investors who wish to buy Swiss government bonds and would like to be repaid within 4 years, now have to accept not a low interest rate, nor even a zero interest rate but a negative interest rate. That is to say the lender pays the borrower real money for the privilege of lending. Similarly in Germany, a 2-year bond was recently issued with a 0% coupon, and on June 1st was trading in the market at above 100 – investors were happy to guarantee a loss if they held the bonds until maturity. Elsewhere government bond yields in the US and the UK are trading at just about their lowest ever levels – lending to governments has never been a less well-rewarded activity and this at a time when governments owe more money than ever before. Greece, has just defaulted, and the media are full of stories of sovereign credit risk. The fundamentals would indicate that this is a very risky time to be lending to governments but most can borrow large amounts very easily and at astonishingly low interest rates.

For Germany and Switzerland the reason for the negative yields is the rising expectation of a potential break-up of the Euro. The Swiss Central Bank has publicly stated that it will print unlimited amounts of Swiss Francs to ensure its currency does not strengthen further against the Euro. However this is not believed by the market due to the long history of conservative Swiss monetary policy. If the Euro were to break up, the demand to convert Euros into Swiss Francs would be enormous, and far greater than the Swiss Central Bank would be prepared to supply. Similarly in the event of a Euro break-up, Germany could be relied upon to have the currency that the world would want to hold. So the negative yields on offer represent the cost of the implicit currency option in the event of a Euro collapse. Germany is the more risky bet here, since it remains the case that one of the few remaining solutions to the crisis, is a much deeper European level of fiscal and political integration in which Germany does assume some liability for the debts of the other nations. If this occurs, Germany’s creditworthiness deteriorates and it may well lose its AAA status.

For the UK and the US, bond yields are positive but are negative in real terms after adjusting for inflation. Yields of around 1.5% over 10 years are below the respective Central Banks’ targets of 2% for the UK and 2.5% for the US. Yields this low are manifestations of demand factors as both the Bank of England and the Federal Reserve have bought large quantities of government bonds with newly printed money. Further the commercial banking systems of both countries have been forced to have much larger holdings of government bonds to bolster their balance sheets. Investor sentiment has been steadily more cautious over the last year, moving away from equity investment and towards more conservative instruments. For most individual investors though, who have to pay tax on the bond coupons, most government bonds  offer negative after-tax yields, even before inflation.

Recent dramatic declines in government bond yields outside the Eurozone periphery, are indicating that the next Euro crisis is close to hand, with attention shifting away from the Greek elections and towards who will recapitalise the bankrupt Spanish banking system. Currently Germany is against every possible solution – it is opposed to (i) common Eurozone bonds, (ii) infrastructure-spending bonds, (iii) bailing out other countries banks, (iv) reducing the drive towards fiscal rectitude, (v) a huge deficit-financed boost to public spending, (vi) the ECB printing money and (vii) any country leaving the Eurozone. Several of these are becoming mutually exclusive, and Germany will have to choose.

Elsewhere in the world, the recent economic news from the US, China, Brazil and India has been disappointing. Growth is slowing and there appears no rush from any policymaker to do anything about it other than to re-iterate their strong desire for growth to occur. Behind the scenes, concern will be growing and some policy action (quite probably co-ordinated) is likely in the next 2 months. This would be good news but may first require a crisis to bring it about. Equity markets are very oversold and cheap if one believes that growth will return again in the near future. Much negative news is priced into financial markets. Longer-term investors can begin to buy some equities at current levels, those with a higher risk aversion may prefer to see the crisis before adding to positions.