If there has been one story dominating markets in the first two months of 2016, it has been the fall in the price of a barrel of oil. Less than 10 years ago, benchmark West Texas Intermediate (WTI) reached $145.29/bbl. The intraday low on 11 February 2016 was $26.05/bbl, itself a 30% fall in the six weeks since the start of 2016. Deflation is back. Weak global aggregate demand is back. Emerging markets in crisis are back. And, of course, market volatility came roaring back, leading to poor performance across most asset classes, even those previously thought to be relatively immune, as investors sought liquidity as much as safety.
Exhibit 1: What goes down, must come up ....after a 30% fall in the first six weeks of 2016, the price of crude oil (West Texas Intermediate (WTI), as of 10 March 2016, has risen 30% from its 2016 lowsSource: Bloomberg, as at 10 March 2016.
There is plenty to be worried about, in what has been an unusually lengthy recovery from the financial crisis. Corporate profitability is down, and the trend is down. Highly accommodative monetary policy in the US has been tightened both by a modest interest rate hike, and an immodest strengthening of the US dollar. The European Central Bank (ECB) was not able to provide as much policy accommodation as it had, arguably, allowed investors to believe was coming. This has led to fears of divisions in its governing council, and worries that the ECB President may not able to deliver quite as much as market participants had been led to believe he could, with more to come on 10 March 2016.
The refugee crisis has exposed strong political divisions across the continent at a time when many worry that coordination is to be desired. The UK's EU referendum on leaving the club altogether is an unhelpful coda. Bad debts to emerging market countries such as China and Brazil evoke, ominiously, memories of the contagion at the heart of the sub-prime crisis, and have manifested themselves in sharp moves in the collateral default swaps of European banks, most notably Deutsche Bank, as the structure of the contingent capital “AT1” has come under pressure. That this structure was designed in the aftermath of the crisis as one way to prevent another is particularly ominious for those who had hoped at the very least the banking run nature of the last crisis might be avoided in the future.
In amongst the gloom, fear, and occasional panic, some data points have quietly been pointing in the opposite direction. The first of these is oil. It is still, to be clear, below its level at the beginning of the year, but is as of 10 March 2016 currently over $10/bbl above its low (see exhibit 1 above). The law of small numbers flatters comparisons, but the gain from the low is in excess of 30%. This has come about from the end of some of the more pernicious effects of margining, but also because marginal producers have begun to cut supply. The effect may be more psychological than anything else given the relative inelasticity of short-term demand, but this is a sizable move.
It is not isolated to oil. Metals have also been rallying hard. Exhibit 2 shows the rally in the price of iron ore - a 30% rise in 2016 (through 04/03/16). Some of that can be seen in the tail, being the 19% rally on 4 March 2016 alone following the opening of the Chinese National People’s Congress, but as the chart also makes clear, this move predates that. Iron is not the only metal which has seen sharp price appreciation: nickel, zinc, and copper amongst others have all moved in the same direction, with those moves predating any suggestion of Chinese stimulus. Emerging market indices have performed well year to date, largely on the back of stronger local currencies.
Exhibit 2: The price of iron ore has rallied hard since the start of 2016 (graph shows the price of the May 2016 futures contract for iron ore)
Source: Bloomberg, as at 4 March 2016.
US payrolls data published on 4 March 2016 came in much stronger than expected, with sharp upwards revisions to prior months. Unemployment in the US remains at 4.9%. Yet the one piece of data inconsistent with the story was US average hourly earnings, which fell -0.1% on the month. However, warehouse retailer Costco increased its hourly wages for the first time in nine years, by 13% for the lowest-paid. Competitor Wal-Mart raised its wages last year. It is always possible to select data to support a viewpoint, but investment bank UBS publishes a Global Inflation Surprise Index. February’s positive surprise was the largest in two years.
No one is arguing that inflation is about to come roaring back. But views predicated on commodity-related gloom injecting deflation into the global economy should be held lightly.
Written on 4 March 2016 in New York City.