Four oil platforms in Aagotnes, Norway. Oil prices have fallen very sharply over recent weeks. ©Tore Meek/Scanpix Norway/PA
Why have financial markets been so poorly behaved so far this year? Take the UK. You may not know it, but the UK is enjoying the equivalent of a £7 billion tax cut. UK motorists consume nearly 1.5 billion litres of petrol each month. The price has fallen about 30% since the peak in the spring of 2013, and half of that decline has happened since the end of 2014. You would imagine this might be a cause for economic joy here and the world over, but no.
Global financial markets are in varying degrees of turmoil. In the first two weeks of the year US equity markets dropped by eight to ten per cent, the FTSE-100 index has now fallen seven per cent, other European and world markets are down 8-11 per cent, and China’s equity market has slumped by 18%. Strategists at two large banks issued warnings last week; one said to "sell everything except high quality bonds," the other opined that the US' Standard and Poor stock market index in the US could drop by 75%. Estimates of economic growth are being lowered again, and some people think we are on the cusp of the next global recession.
A barrel of Brent oil that cost $125 in 2013, and still $65 in the first part of 2015, closed at over $28 at the end of last week. It really is bizarre that financial markets and commentators have come to view lower oil prices as bad news. The corollary is that it would be good news if oil went back to $100 a barrel as quickly as possible, which is nonsense except for oil producing companies or states.
So why are flailing markets and a collapsing oil price, which give off diametrically opposite macroeconomic messages, locked in some sort of death spiral
What’s happening is that a major commodity bubble is being unwound. It started in about 2005-06 and continued until 2014, punctured by the financial crisis in 2008-09. The principle catalyst for the bursting is that commodity-intensive growth and economic reform in China have stalled, but there is also a wider hiatus in economic growth in emerging markets. In the energy market specifically demand growth is slowing, while a major supply shock has permeated the market thanks to US oil and gas production, and the decision by Saudi Arabia and other Gulf producers to maintain high levels of output. (They have taken that decision, in part, to put countries like the US and Russia (and Iran) under pressure.) According to the International Energy Agency, oil inventories have been at near record highs of about three billion barrels. Now that sanctions against Iran will be lifted, an additional 0.5 million barrels a day could start flowing.
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As the bubble built and commodity asset prices soared, energy and mining companies built up their investments, and their liabilities, which were funded by bonds and bank loans. Now that asset prices are dropping like a stone, companies are being forced to cut back their capital spending sharply, cut costs including dividend payments, preserve cash-flows as best they can, and scramble around for liquidity as financial obligations fall due. Global equity markets that had been buoyed by the rise in energy and mining company capitalisation in the bull market are now going the other way. Part of the "panic" in financial markets may well be a fear or concern for the financial integrity of some commodity trading companies, including very large and well known ones. We shall see. If that happened, there might then be further implications for banks especially exposed.
It would be wrong to say that the commodity bubble bust is the only reason for the weakness in world equity markets. Consumer, technology and other non-materials stock prices have fallen too, though by proportionately less. Investors and traders are concerned that the downdraft in the energy and commodity sectors will drag down earnings and economic activity in the broader economy, especially as already low inflation drops further. China is sapping market confidence, because of what is going on in the economy, the flight capital leaving the country, and the apparent confusion that seems to pervade much policy-making nowadays. Furthermore, a raft of economic indicators in the US and Europe for the end of 2015 meant the year ended on a soft note: US GDP may have risen by barely 1% at an annual rate in the last quarter of the year. And the Federal Reserve’s decision to raise rates just before Christmas with the intent of doing more in 2016 wasn’t viewed as such a good idea for stock prices. The Fed may now have to tone its rhetoric down, and expectations that Mark Carney might soon give a steer as to when UK rates have also been pushed back again.
But even if the equity markets are in a bad mood, that doesn’t mean we have to conflate this with another imminent global recession. The most likely outcome, assuming that there is no rout in equity markets, is that we will muddle through a period of economic weakness. It is true that layoffs and unemployment in China are starting to rise, but there aren’t many, if any strong indicators of new weaknesses in labour markets in the US, Europe or Japan. We have certainly never had a recession against a backdrop of a collapse in oil prices, while those from 1973 onwards were all preceded by a surge.
It could well be that the propensity for people and companies to spend money nowadays is not the same as it used to be. Perhaps the debt crisis and for some, the continuing debt burden, has made people more reluctant to spend windfall gains, such as the savings on filling the car up. But once the current shocks from the energy price collapse have been absorbed, the benefits to households’ real incomes and to non-energy company profits and investment should become more transparent. Fingers crossed.
