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Macro Insight February 2015 Lower oil prices: Causes and implications For professional clients and institutional investors only Summary Why have oil prices fallen? The over 50% fall in oil prices since June 2014 has been primarily supply-driven, though weak demand has also played a part. Since their peak in June 2014, oil prices have tumbled by over 50%, with both WTI and Brent crude falling by around USD60 per barrel (Figure 1). This has been driven primarily by a surge in supply, though weak demand has also played a part. Since June, oil produced by Organisation of the Petroleum Exporting Countries (OPEC) members has accelerated considerably. This is partially due to Iraq being able to meet its production targets, despite escalating geopolitical tensions, and a better-than-expected recovery of Libyan oil production. In addition, nonOPEC oil supply has continued to grow at a strong rate, driven by the US shale revolution. On the demand side, weaker global economic growth expectations have also exerted pressure on oil prices. Despite the US experiencing robust growth in the latter half of 2014, the Chinese economy has continued to slow, growth in the Eurozone remains stagnant and Japan has recently entered recession. It is important to note that weaker demand has also contributed to considerable falls in other commodity prices, such as coal, copper and steel. Lower oil prices will exacerbate global disinflationary pressure, but should provide a net boost to global growth, though there will be winners and losers among countries. With the exception of the energy sector, equities have proven to be fairly resilient to falling oil prices. Historically, defensive stocks such as healthcare and utilities appear to outperform relative to the broader market index when oil prices are falling, while materials and industrials underperform. Within fixed income markets, nominal developed market government bond yields have fallen, driven by deteriorating inflation expectations, while US high yield spreads have widened considerably. The net boost to global growth should be supportive of risk assets such as equities. An attractive entry point for high yield credit may also arise should oil prices stabilise, or even rebound, given the recent spread widening. Figure 1: Oil prices have collapsed by over 50% since June 2014 Falling oil prices have led to perceived “safe-haven” developed market government bonds becoming increasingly less attractive, given that yields have fallen considerably since June. However, the recent bouts of market volatility and increased risk aversion highlight the need to construct a well-diversified portfolio. Source: Bloomberg, February 2015 1 PUBLIC Figure 2: The fall in oil prices has been primarily driven by a surge in global supply Source: Energy Intelligence Group, HSBC Global Asset Management, December 2014 Although global supply and demand forces had been pointing to an oil supply glut for many months, oil prices were supported by the belief that OPEC would react by cutting their production targets, as they have done in the past. However, at the November OPEC meeting, the oil cartel decided to take no action, thereby maintaining its aggregate production target of 30 million barrels per day. Indeed, Saudi Arabia’s oil minister stated that it was “not in the interest of OPEC producers to cut their production” given that at current lower prices their market share is likely to increase. The outcome of the meeting caught the market off guard and triggered a steep sell-off in oil prices. As a result of recent developments, financial market participants have revised down their oil price forecasts significantly, both in the short and long terms. Interestingly, the current prices of crude oil futures contracts imply that lower oil prices are likely to persist, futures prices suggesting that WTI crude oil will remain below USD60 per barrel for the next twelve months (Figure 3). This likely reflects an expectation that global oil supply will remain relatively high, with both OPEC and the US unlikely to cut production soon, while global demand is expected to remain subdued, particularly as China attempts to rebalance its economy and make it less commodity-intensive. However, market expectations and implied futures prices can change rapidly, especially in the face of a significant supply shock such as a sudden escalation of geopolitical risk or a cancellation of oil projects as producers react to lower oil prices. Macroeconomic implications Figure 3: Crude oil futures currently suggest that the recent fall in oil prices is likely to persist Figure 4: Oil producing countries that have high fiscal breakeven prices are the most vulnerable Source: Bloomberg, at of February 2015. Source: IMF, HSBC Global Research, Ecuador Finance Ministry Lower oil prices should provide a net boost to global growth, though there will be winners and losers A fall in oil prices will likely provide a net boost to global economic growth, primarily through higher consumption as real household incomes rise, and through lower input costs. Indeed, a recent simulation conducted by the International Monetary Fund (IMF) estimates that global GDP growth in 2015 will increase by 0.3-0.7% compared to a scenario without the drop in oil prices. Although the global economy is likely to benefit in aggregate, there will be a significant distribution of wealth from oil producers to oil consumers. Oil consumers, such as the US, Eurozone, Japan and China, are likely to benefit from lower oil prices through a boost to real household disposable income, lower manufacturing input costs and improved current account positions. Of course, the strength of these effects will vary across countries. For example, China and India are likely to benefit the most from the real income effect given they have a large share of oil consumption as a percentage of GDP. Similarly, US consumers are likely to benefit more than UK consumers due to the lower level of fuel taxes in the US than in the UK, though there may be potential job losses in the US shale energy sector. 2 PUBLIC However, the effect of falling oil prices on oil producers will undoubtedly be negative and will detract from economic growth through falling oil revenues and profits. The economies that are most vulnerable are likely to be those that have high fiscal break-even prices, that is, the price of oil at which governments of oil-exporting countries are able to balance their government budgets. These notably include Venezuela, Nigeria and Saudi Arabia (Figure 4). Russia is also particularly vulnerable given that energy accounts for 70% of its exports and half of government revenues. What has the impact been on other asset classes? Although falling oil prices have triggered bouts of volatility and increased investor risk aversion over recent months, equity markets have proven to be fairly resilient. Indeed, the MSCI World index excluding the energy sector has posted a gain of over 4% in local currency terms since June (as at 30 January 2015), while energy stocks have fallen almost 25% over the same period (Figure 5). Within emerging markets, it is noticeable that Asian equity markets, which are majority oil consumers, have outperformed their Latin American counterparts, who are generally highly reliant on commodity exports, including oil (Figure 6). Headline inflation will fall considerably across the world, though the Fed may “look through” this when determining its monetary policy Falling oil prices will also translate into lower inflation. Indeed, the recent decline in oil prices has already led to the Eurozone slipping into deflationary territory from December, while the most recent inflation data in the US and UK also showed prices dropping sharply, with both economies likely to experience deflation at some point this year. Within emerging markets, falling oil prices have so far had a mixed impact on inflation. Although Brazilian inflation has edged slightly lower, both Indian and Chinese inflation actually picked up in December as a result of favourable base effects and a sharp rise in food inflation, which is typical in the runup to the Chinese New Year. These effects are likely to only be temporary however and falling oil prices will weigh on inflation in the months ahead. In Russia, inflation has soared, but this has been driven by a sharp depreciation in the rouble. Figure 5: Equities have proven to be fairly resilient since June 2014, though energy stocks have underperformed Source: Bloomberg, HSBC Global Asset Management, February 2015 Past performance should not be seen as an indication of future returns In terms of monetary policy, the US Federal Reserve is likely to err on the side of “looking through” the temporary fall in headline inflation caused by lower oil prices and focus instead on the improving health of the labour market and its impact on core inflation. However, given medium and long-term inflation expectations have deteriorated in recent months as a result of falling oil prices, there is an increased probability that rates may stay lower for longer, which would be supportive for both equity and fixed income markets. Figure 6: Emerging Asia equities have outperformed their Latin American counterparts as oil prices have fallen In paralel, the European Central Bank and Bank of Japan are likely to continue their accommodative monetary policy stances as they aim to fight off disinflationary pressures and falling inflation expectations. The Bank of England also struck a more dovish tone in its November Inflation Report, citing a deteriorating growth and inflation outlook as a reason to delay the timing of its first interest rate rise. Indeed, the two members of the MPC who were previously pushing for a rate rise in mid-2014 have now stopped doing so. Source: Bloomberg, HSBC Global Asset Management, February 2015 Past performance should not be seen as an indication of future returns 3 PUBLIC Figure 7: Previous occasions when oil prices have fallen by over 50% Change in MSCI World Index (%) Change in US Treasury 10Y Yield (bps) -60.3 14 -189 - -54.9 16.4 -91 1260 33.9 -76.7 -30 -185 1274 49.3 -54 2.1 -96 260 Start Price (WTI, USD/bbl) End Price (WTI, USD/bbl) Price fall (%) 4 31 12.3 5 39.7 17.9 Demanddriven 5 145.3 Supply-driven 8 107.3 Start End Dynamics No. Months 1 Nov-85 Mar-86 Supply-driven 2 Oct-90 Feb-91 Supply-driven 3 Jul-08 Dec-08 4 Jun-14 Present Change in Barclays US HY Spread (bps) Note: MSCI World performance expressed in local currency terms. Source: Bloomberg, HSBC Global Asset Management, 30 January 2015. Past performance should not be seen as an indication of future returns Over the last 30 years, we have identified three previous occasions when the oil price has fallen by over 50% in the space of a few months (Figure 7). Interestingly, the two supply-driven oil price collapses identified (in 1985-1986 and 1990-1991) coincided with equity market rallies. For example, from November 1985 to March 1986, the over 60% fall in the oil price, triggered by Saudi Arabia ramping up its production to full capacity in order to defend its market share, facilitated a 14% rally in the MSCI World index in local currency terms during the same period. Developed market equities have not experienced as strong a rally this time around, with the MSCI World Index returning just over 2% in local currency terms (as at 30 January 2014). However, there have been large differences between regions, with Japan’s Nikkei 225 rising over 15% as the Bank of Japan provided further monetary stimulus, while US stocks were weighed down by a stronger USD and European equities were held back by concerns over economic growth momentum and disinflationary pressures. Emerging market equities have also experienced differences within regions, with commodity-consumers broadly outperforming commodity-producers. Looking forward, equity markets should be supported by a falling oil price if it translates into a much-needed boost for the global economy, benefitting energy consumers the most. Defensive stocks such as healthcare and utilities appear to outperform relative to the broader market index as oil prices fall, while materials and industrials underperform. Indeed, these sector trends appear to be fairly consistent over time, as illustrated in Figure 8. Within fixed income markets, yields on developed market government bonds have fallen since June, reflecting deteriorating inflation expectations. 10-year US Treasury yields have fallen over 96bp to 1.64% and German 10-year bund yields have fallen over 100bp to 0.30% (as at 30 January 2015), though expectations of ECB quantitative easing is likely to have also contributed. The fall in government bond yields is consistent with what has been observed through time. “Safe-haven” developed market government bond yields have fallen in each of the three previous occasions identified where the oil price has fallen by over 50%, again driven by falling inflation expectations. In contrast to the strong performance of developed market government bonds, the US high yield market has experienced significant spread widening over the past few months (Figure 9). This is driven by the fact that energy companies have significantly increased their share of the US high yield benchmark, with a weight of approximately 15% in 2014, compared to less than 5% ten years ago. Looking back to the previous periods of large oil price falls identified, US high yield spreads also widened substantially. However, the spread widening observed in both 199091 and 2008 was each time associated with recessions and soaring high default rates, which is not the case today. Within sectors, energy stocks have significantly underperformed since June, as expected. However, across other equity market sectors, the impact of falling oil prices has been more varied. Figure 8: Historically, defensives such as healthcare and utilities have outperformed as oil prices fall Figure 9: US high yield spreads experienced significant widening as oil prices tumbled Source: Bloomberg, HSBC Global Asset Management, February 2015 Past performance should not be seen as an indication of future returns Source: Bloomberg, HSBC Global Asset Management, February 2015 Past performance should not be seen as an indication of future returns 4 PUBLIC Investment Implications Assuming oil prices remain at or around current levels, the global economy should receive a net growth boost over the coming months, which should be supportive of risk assets such as equities. An attractive entry point for high yield credit may also arise should oil prices stabilise, or even rebound, given the recent spread widening. Perceived “safe-haven” developed market government bonds have become increasingly less attractive given yields have fallen considerably since June, driven by deteriorating inflation expectations. However, the recent bouts of market volatility and increased risk aversion highlight the need to construct a welldiversified portfolio. Moreover, the anticipated transfer of wealth from oil producers to oil consumers will likely cause differences in performance between regions, while sector performance has also varied considerably over time in response to oil price changes. Shaan Raithatha Macro and Asset Strategy team Julien Seetharamdoo Chief Investment Strategist Michael Hampden-Turner Senior Macro & Investment Strategist Julien Seetharamdoo is Chief Investment Strategist within HSBC Global Asset Management’s Macro and Asset Strategy team where he provides analysis and research on the key issues facing the global economy and asset markets. Prior to joining HSBC, Julien has worked for Coutts & Co, RBS and Capital Economics. He holds a first-class degree in Economics from Cambridge University and a PhD in Economics from the Management School, Lancaster University focusing on the implications of the European Monetary Union. Michael Hampden-Turner is a Senior Macro and Investment Strategist based in London having recently joined HSBC Asset Management in December 2014. He previously held global macro, asset allocation, fixed income and credit strategy roles at Citigroup and RBS over a twenty year career both as a publishing top down strategist and a desk analyst. He studied at Trinity College, Cambridge and Harvard University. Renee Chen Senior Macro & Investment Strategist Rabia Bhopal Macro & Investment Strategist Renee Chen joined HSBC Global Asset Management as Macro and Investment Strategist in April 2012. Prior to this role, she held Economist roles at Macquarie Capital Securities, Nomura and Citigroup and has over 14 years’ experience in economic and policy research. Renee holds a master’s degree in International Affairs and Economic Policy Management from Columbia University, New York and an MBA in Finance and Investment from George Washington University, Washington DC. Rabia Bhopal is a Macro and Investment Strategist and provides analysis and research on the key issues facing the global economy and asset markets, with particular focus on Frontier Markets. Rabia has been working in the industry since 2003. Prior to joining HSBC in 2012, Rabia held Economist roles at Standard & Poor¹s, Lloyds TSB Corporate Markets, Financial Services Authority and the Economist Intelligence Unit. She holds a degree in Economics from Brunel University in London. Herve Lievore Senior Macro & Investment Strategist Shaan Raithatha Junior Macro & Investment Strategist Hervé Lievore is a Senior Macro and Investment Strategist based in Hong Kong. Before joining HSBC, he spent five years at AXA Investment Managers in London and Hong Kong as an economist and strategist, covering Asia and commodities. He was also involved in the firm’s tactical asset allocation committees. He started his career 18 years ago at Natixis in Paris, where he mostly covered Asian markets. Shaan is a Junior Macro and Investment Strategist within HSBC Global Asset Management’s Macro and Investment Strategy team. Prior to this role, he spent 18 months on the HSBC Global Asset Management Graduate Programme working as an analyst on both the Global Emerging Markets Equity and Equity Quantitative Research teams. 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