Blog - AAM: ‘It’s not as bad as it looks’



 

Lucy Carroll
Lucy Carroll

Lucy O’Carroll, Aberdeen Asset Management chief economist gives us her ‘Bear necessities’

 

Economists love rules of thumb, and here’s one: a sustained 10 per cent fall in oil prices boosts global annual GDP growth by 0.2 percentage points (pps) in the next two years. But to say that markets haven’t been responding to the latest oil-price falls with this rule in mind is something of an understatement. So is the rule wrong, or are markets focusing on other things?

Rules aren’t what they used to be… When oil prices began falling in mid-2014, it was widely assumed that the global effects would be positive. But there are at least four reasons why the rule of thumb may not be working under current circumstances:

  1. The rule assumes that the entire fall in the oil price is supply-driven: to the extent that it reflects weaker global fundamentals – and to some extent it does – the boost to real GDP growth will be more muted.
  2. Central banks may not be adding as much to the oil upside as they used to: part of the rationale for expansionary oil-price falls has been that they free central banks to keep monetary policy loose, at least in the short term, because lower oil prices reduce headline inflation. But this benefit is much less meaningful when inflation is already well below target and interest rates on the floor.
  3. The redistributive effects of falling oil prices may have changed: the conventional story is that falling oil prices boost net global activity by redistributing income away from those (such as oil-rich Middle Eastern states) with low propensity to spend towards those (such as low-income Western households) with high propensity to spend. Arguably, however, the rise of fracking may have altered this balance, on the basis that producers’ investment spending has far shorter lead times than in the past and is therefore more closely tied to current oil prices. As a result, the boost to net global spending from falling oil prices may be weaker than in the past.
  4. Oil-price moves may have non-linear effects on global activity: the rule of thumb implies that the more oil prices fall, the larger the positive effects on global activity – but what if this isn’t true? The price adjustment since mid-2014 has been huge: from over $140 per barrel (pb), and expected to rise, to under $30 pb, and potentially falling further, in 18 months. The impact on producers – whether governments or corporates – has likewise been substantial. So while modest falls in oil prices of $10-20 pb may be expansionary via the ‘usual’ consumption channels, really big declines could set in train a process of forced deleveraging amongst producers - whether in the form of Saudi Arabia’s austerity measures or corporate failures in the US energy sector – that actually harms global growth, not underpins it.

But these explanations most likely reduce the power of the rule, not upend it – except for Reason 4, which creates a downside risk… Reasons 1-3 help to explain why the boost to global growth from falling oil prices may be more muted, or slower to emerge, than in the past. But they don’t suggest that the rule of thumb has been turned on its head. Reason 4 is slightly different. At its worst, it suggests that very low oil prices could cause such serious problems for oil producers that a ‘Lehman moment’ is triggered – via US banking sector stress, country default or sovereign wealth fund (SWF) liquidating assets on a massive scale to bolster national finances.

While a ‘Lehman moment’ may be a risk, it isn’t the most likely outcome… First, there is not a direct read-across from the real-estate nub of the 2007-08 global financial crisis (GFC) to the energy sector’s present problems. In the former, the global banking sector was massively exposed via both its corporate and residential property lending, much of it cross-border; holdings of sub-prime debt in its investment arms; and, in some cases, equity stakes in real estate companies. While the energy sector’s difficulties may have implications for US banks with sectoral and regional exposures, these are of a different order of magnitude to the GFC, particularly given capital markets’ role in the financing of the US energy sector. Furthermore, the boost to real incomes from falling energy prices should provide the financial sector with opportunities in other areas. And while country-level distress is a potentially serious issue for the most vulnerable economies – such as Venezuela – a really large ‘bust’ would most likely require oil prices to fall further and stay exceptionally low for a far longer period than seems likely, given supply/demand fundamentals.

So markets seem to be focusing on the risks, not the rule… Even if worries about a GFC-type blowout seem overdone, markets may be responding to a worry that low oil prices reflect an as-yet-unmeasured slowing of global growth, one that is far larger than is apparent in the recent macro data. Falling oil prices have not  historically played such a role in ‘calling’ global crises, particularly when the fall has been substantially supply-driven, but the danger may be that against the current backdrop of increased uncertainties – over oil prices themselves, China’s slowdown and the path of US policy – herding behaviour takes over and the drop in oil prices and equity markets becomes a self-fulfilling prophecy.

What we really need from here is stabilisation… We do not believe that the macro fundamentals are as bad as recent market moves suggest. If markets regain some faith in these fundamentals – and in the oil-price rule, even if a weaker variant – in the days ahead, the current situation could be another August 2015-style hiccup. The longer it takes to achieve stabilisation, the greater the self-fulfilling prophecy risks.

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