FEARS OVER OIL AND DEFLATION ARE EXAGGERATED / THE FINANCIAL TIMES COMMENT & ANALYSIS

On Wall Street

January 9, 2015 2:55 pm

Fears over oil and deflation are exaggerated

Henny Sender

Other concerns, such as those on US growth, are underplayed

 

 

The first few trading days of 2015 brought a mixed message about financial markets. The year began with a five-day decline on Wall Street before the stock market reversed course and rallied.

 

However, as equity investors took profits on a volatile but ultimately benign 2014, uncertainty replaced optimistic conviction. That conviction was based largely on the promise of continued zero rates in the US and more quantitative easing in Europe and Japan. Suddenly, though, central bank support is no longer enough.

 

In some ways, this uncertainty is justified. Easy money has always had its limits: no policy can lead to ever higher asset prices, whether that policy is finite or not. But some of the big fears giving rise to market jitters are exaggerated, notably those around oil prices and deflation.

Other concerns are underplayed, in particular fears that share prices are out of line with fundamentals such as earnings, and that US growth prospects are less robust than forecast.

 

The oil shock is the first big fear spooking the markets, but the positive effects should outweigh the negative. It is true that the 50 per cent slide in the cost of a barrel of oil will hurt the profits of energy companies. It will also lead to defaults in the high yield market where alternative energy companies issued their debt; indeed, JPMorgan Securities thinks 40 per cent of these issuers could default by 2017 with oil prices below $65. Since these energy firms account for about 17 per cent of all issuers, that could trigger more risk aversion in the market generally.

 

There may be further, second-round effects that are destabilising. It is not clear, for example, what the consequences of fewer petrodollars to recycle will be. For Saudi Arabia, with its trillion dollars in foreign reserves, it is unlikely to be a big deal. Nor will fewer petrodollars going into US Treasuries be a problem — plenty of other people will want them. But for Algeria, Nigeria or Venezuela, or for that matter Russia, there could be more serious effects.

Still, for everyone else, and especially for those who live in a dollar world and therefore get the full benefit of the fall in oil prices, the transfer of income from oil producers to oil consumers is a good thing. It will support consumption in the US far more effectively than the Federal Reserve’s policies.

 

The second overplayed fear that has made the markets tremble at least intermittently is the prospect of deflation. Too many economists have bought into the argument that all deflation is bad. In fact, deflation is not necessarily terrible for everyone. It increases real income, though it is worse for borrowers than for savers because they cannot rely on inflation to erode the real burden of repayment.

Moreover, much of the deflation in the world today comes from technological breakthroughs and advances in productivity that have lowered the cost of many things, which should be another positive factor for markets.

In addition, at a time when workers have little pricing power and therefore see little wage growth, deflation is better than inflation, which would further erode purchasing power. This is why the policies of Shinzo Abe, Japan’s prime minister, are dangerous: higher inflation for everything but wages and a population of fewer and older people means domestic demand in Japan can only shrink.

 

The combination of lower oil prices and deepening deflation does not mean, though, that the world is a more benign place now than in the past few years. Fears about the strength and quality of growth in the US, and the sustainability of stock market gains are absolutely justified, but underplayed. Data from the end of the year suggest companies in the US are not investing in their businesses.

“The growth of US business equipment spending stalled in 4Q,” note the economists at JPMorgan. “We are cutting our capex growth forecast to zero.”

Moreover, in 2013, stock market gains had little to do with corporate earnings, although in 2014 they were more in line. The key to producing increases in key metrics was either through mergers to buy growth or through share buybacks (up 25 per cent in the third quarter of 2014 over the previous one).

Earnings growth will be more elusive in future while share prices will appear even more expensive against anaemic earnings growth.

The one consensus view that remains reasonable is dollar strength. The challenge will be figuring out where to put those dollars.