Oil, Europe, Good and BadJanuary 6, 2015
Less than two months ago, Oxford Economics modeled sensitivity to the oil price by conducting simulations on 47 countries. Their baseline then was an “$84 Brent crude price average in 2015… gradually recovering to $106 in 2019.” Their updated work has tested further simulations with $70, $60, $50 and $40 per barrel oil against that baseline.
In Europe, they projected “negative inflation,” which is not exactly the same as “deflation,” in the Eurozone. In this instance, however, negative inflation might just as well be deflation, since we are talking about declines in price levels or changes in direction of prices such that they have a downward bias. Of course, the simulations require that the decline in the oil price persist, in order for behavioral changes to occur in these economies.
The simulations attempt to measure the imbalances among countries and how these grow wider (with conditions worsening for some and improving for others) as the oil price sustains a lower level. Impacts on bond yields are projected for these diverse scenarios. The takeaway is how remarkable the disparities among countries become as the oil price falls. For those with falling yields, the levels are extraordinary. For those with rising yields due to credit issues, the mirror image is true.
In Asia, the Philippines is potentially one of the largest beneficiaries of low oil prices. So is Japan. Both are in Cumberland’s international portfolios. Russia, Venezuela and others of similar ilk, as expected, are severely penalized. Cumberland does not own them.
Spain is a big beneficiary in Europe. Out of the 45 countries Oxford considered, at the baseline oil price ($84), Spain is the only country to have negative inflation in 2015. As the price falls, more and more countries make this list. At $40 per barrel, 21 countries (47 percent) make the list. The leaders are all in Europe and mostly in the Eurozone. In order of impact as measured by negative inflation, they are Spain, Bulgaria, Italy, Poland, Portugal, Sweden and Switzerland (which is now pegging its currency to the euro). At $60 per barrel for Brent, a majority of the Eurozone countries make the list. At $50 the entirety of the Eurozone does. Remember that “negative inflation” from an external shock acts as a rise in real income for Europeans.
Simply put, low oil prices mean no inflation in the Eurozone, and there is nothing the European Central Bank can do to change that outcome. It also means that the potential for massive quantitative easing by the central bank is growing daily. We expect the ECB to announce large programs and to fulfill their goal of taking their balance sheet above 3 trillion euros. They will find a way to do it by linking the sovereign debt of each country to the creditworthiness of that country so that a combination package pairs debt and credit enhancement. The pairing can be used as collateral in a QE structure. Mario Draghi is about to deliver on his “whatever it takes” promise. We expect this development very soon. Meanwhile, the composition of the ECB Governing Council is about to change. It will become harder and harder for Germany to block a QE program.
Now back to a bottom line: 2015 is shaping up to be a challenging year for investors and their advisors. We expect higher volatilities in many markets, surprises from unanticipated corners and a lot of monetary stimulus in Europe. At the same time, the US will lead the world, and our growth rate now looks likely to be closer to 3.5 percent for the year. Cheaper oil is a wonderful thing for the winners. The gap between them and the losers will certainly widen.
The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.
The preceding is a commentary by Cumberland Advisors and has been reposted with permission. Cumberland Advisors commentaries are available at http://www.cumber.com/commentary_archive.aspx.
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