FINANCIAL REVIEW

Oil and Implications

Sinclair Noe — December 2, 2014

Podcast: Play in new window | Download (Duration: 13:15 — 6.1MB)

DOW + 102 = 17,879
SPX + 13 = 2066
NAS + 28 = 4755
10 YR YLD + .07 = 2.29%
OIL – 1.48 = 67.52
GOLD – 14.30 = 1199.50
SILV un = 16.57

Record highs on Wall Street. The day’s gains were broad, with nine of the 10 S&P 500 industry sectors higher. The only group to fall was telecoms. I think this is the 32nd record high for the Dow this year; pretty soon we’ll be counting them in dozens.

Records for the bond market as well. US corporate bond sales for 2014 have topped $1.5 trillion, setting a new annual record, as borrowers lock in low rates. According to Lipper, investors have poured money into corporate investment-grade funds for 24 straight weeks, with inflows of $880 million for the week ending Nov. 26. Borrowers have offered $1.168 trillion of investment-grade notes in 2014 and $344 billion of junk bonds. Yields on corporate bonds in the U.S. fell to 3.57 percent in June and have since risen to 3.86 percent yesterday.

So, record highs for equities, record issuance for corporate bonds; the story line is that this is a good place to be, and when you look abroad, it makes sense. Yesterday, Moody’s Investors Service cut Japan’s credit rating to A1. Japan is in a recession after a sales tax increase in April destroyed consumer demand, and Prime Minister Shinzo Abe is facing a vote of confidence, and he is likely to retain a majority. As for Europe, well, don’t hold your breath waiting for the ECB to ride to the rescue.

Meanwhile, Russia is headed for a recession. The economic development ministry revised its GDP forecast for 2015 from growth of 1.2 percent to a drop of 0.8 percent. Russian households are expected to take a hit, with disposable income seen declining by 2.8 percent against the previously expected 0.4 percent growth. Sanctions over Moscow’s role in eastern Ukraine are making things worse, hurting Russian banks and investment sentiment in particular. Russia’s economic outlook is at the mercy of the global market for oil, their national budget depends on it.

Another consideration is that Russia and Iran want to escape Western sanctions, meanwhile China continues to demand more oil, and the counterpunch is to trade oil without dollars. We hear warnings that we are seeing the early signs of a transformation in the global monetary system, away from the petrodollar, away from the dollar as the reserve currency. But that hasn’t happened yet, and today the Russian ruble continued its descent to fresh record lows. The result is a very disorderly capital flight from Russia, requiring the Russian Central Bank to step in and buy rubles, and raising the risk of emergency exchange controls. Some Russian banks have already started limiting withdrawals of dollars and euros to $10,000, an implicit lockdown for big depositors. Danske Bank says Russian “funding problems are increasing dramatically,” and “Russia is now flirting with systemic problems.”

Oil prices continued to fall today as a Saudi prince declared that the kingdom would only consider cutting oil production if Iran, Russia and the US agreed to match those cuts because it wants to protect its market share. There is more to the Saudis’ position; they know that low oil prices hurt Russia and Iran, both supporters of Assad in Syria. But today, the Saudi royal line was that falling prices are a result of “over-production everywhere” and not a pre-meditated strategy by Saudi Arabia.

Whatever the cause, the result could be one of the biggest transfers of wealth in history, potentially reshaping everything from talks over Iran’s nuclear program to the Federal Reserve’s policies to further rejuvenate the U.S. economy. Every day, American motorists are saving $630 million on gasoline compared with what they paid at June prices, and they would get a $230 billion windfall if prices were to stay this low for a year. The vast majority of that will flow into the economy, with lower-income households living on tight budgets likely to use money not otherwise spent on gas to buy groceries, clothing and other staples. At current prices, the annual revenue of OPEC members would shrink by about $600 billion, money that will instead stay within the borders of the world’s biggest oil importers, led by the United States, China and Japan.

Although falling oil prices lower inflation, the Federal Reserve claims the low inflation is probably temporary, and they are not altering their underlying judgments about policy. Nonetheless, the slump in oil prices may also help to persuade the European and Japanese central banks to implement further monetary easing as prices remain subdued. It was just about 3 years ago that oil prices, and other commodity prices were on the rise and headline inflation was running a bit higher; back then the argument was to strip out energy from the inflation consideration, and that’s what the Fed did. Meanwhile the ECB did not and they raised rates in Europe, which turned out to be incredibly stupid.

So now that oil is plunging, the same people who saw rising oil as a reason to raise rates should see falling oil as a reason for expansionary policy, right? Not exactly. Now we’re being told to pay no attention to low headline inflation, which they say is just oil, and anyway falling oil prices are a stimulus. So when oil is going up, it’s a reason to tighten policy, and when it’s going down, it’s a reason not to loosen policy.

Meanwhile, the stock market has been hitting record high after record high, corporate bonds are all the rage, and Treasury yields have dropped. Not small moves by the way. From mid-October, equities have surged almost 11% while commodities have fallen 7%. Equity rallies that include a series of record highs after an impressive multiyear advance, which has been the case this year, are usually underpinned by robust economic growth. And last week we saw third quarter economic growth revised higher to 3.9%, which is good; and unemployment continues its steady decline to 5.8%; but it is hardly the sort of economic growth that could be called robust. It doesn’t seem to merit unrelenting records in stocks and it isn’t enough to lift the economy to escape velocity. And if economic performance is really stronger than it looks and feels, and if the stock market is correct in its valuations, then we are setting up a big divergence in bonds and commodities, which are pointing to weaker overall growth.

More and more it looks like equity prices are propped up by share buybacks and dividend hikes and creative accounting, along with the otherwise untouched piles of cash on corporate balance sheets. Meanwhile fixed income investors chase yield and double up on everything with little regard for risk. At some point, the divergences will be brought into balance by economic and policy fundamentals, and that means that we need to see global economic growth if the stock records of today are to be believed, or we will see the bond and commodity markets were right and the stock markets will be dragged down to that level.

In economic news today:
The Commerce Department says construction spending rose 1.1% in October, after having slipped 0.1% in September. Fueling the gains in October was a 1.8% increase in spending on single-family houses. A similar boost in building schools increased government construction spending 2.3%. Total construction spending has climbed 3.3% from a year ago to $971 billion. Still, the solid growth in homebuilding underlines that sector’s weakness during much of the past year. Over the past 12 months, private residential construction spending has risen just 1.9% to an annualized rate of $353 billion.

Ford Motor sales declined 1.8% last month compared to November 2013, the company reported Tuesday. While a slip was anticipated the 187,000 vehicles sold was a weaker showing than anticipated. Ford still sells more trucks than cars or utility vehicles but that figure declined 9.9% to 70,903. The bright spot for Ford – Mustang sales were up 62%.

Chrysler, which is now a part of Italy’s Fiat Chrysler Automobiles, showed a 20% year-over-year increase in U.S. vehicle sales last month for a total of 170,839 units sold. This marks the group’s strongest November sales in 13-years with all five of its existing brands (Chrysler, Jeep, Dodge, Ram Truck and Fiat) posting gains.

General Motors reported a 6% increase in sales delivering 225,818 vehicles in November. Retail sales were up 5% which fleet deliveries grew 11%. Meanwhile the recall troubles continue at GM, as they are recalling 273,182 midsize SUV’s and Buick LaCrosse sedans in the U.S. because the low-beam headlights can cut out, temporarily or permanently. When vehicle in other countries are included, the total climbs to 316,357. The headlight recall brings the total number of GM recalls this year to 79. The total number of vehicles involved is 24.5 million.