Throughout 2013 and into the early part of 2014, Brent crude oil prices remained in a stable range between $100 and $110 per barrel (bbl). In June, however, the price rallied up to $115 per bbl following concerns about the spread of Islamic State and resulting fears about the impact on oil production. These fears were assuaged once it became clear that production in southern Iraq would be unaffected by the turmoil, although instability elsewhere in the Middle East continued and oil prices quickly reversed their gains.
Prices continued their downward trend over September, breaking the psychological level of $100 per bbl and then falling by a further 10 to 15 percent. The fall in oil prices has been one of the drivers for the sharp sell-off in equity markets. Rather than investigate the causes of the oil price fall, we have focused here on the future implications for asset classes and the broader outlook.
All else being equal, the medium-term consequences of lower oil prices, if sustained, should be beneficial for global consumption. According to Citigroup, the decline in energy prices could generate an annualized global boost to the tune of $660 billion. Within the U.S., a 20 percent fall in oil prices would lead to a household windfall of $600 a year, assisted by gasoline prices returning to 2011 levels.
For energy-exporting countries, this move has negative implications, as government revenues will fall short of budgeted expectations. The countries that stand to be the most affected by this revenue shortfall include Russia, Canada and Saudi Arabia. For energy importers, this has quite the opposite effect. Countries like India, where oil accounts for the largest share of commodity imports, and South Korea are net beneficiaries of lower energy prices. The cost of energy has had a substantial annual drag on the overall trade deficit. If crude oil prices hold at these levels for the next year, we would expect to see a substantial improvement in India’s overall trade balance — something we feel adds conviction to our overweight Indian rupee exposure.
Apart from growth, falling energy prices also have implications for inflation. Energy has a relatively high weighting in the Europe-wide consumer price index. We estimate that the recent falls in energy are likely to knock as much as 1 percentage point off the level of the harmonized index of consumer prices. This has not just dovish implications for European policymakers but also worldwide implications for monetary policy. In the short term, any expected tightening in policy will likely be pushed further out. Central banks that are in easing mode will likely continue that policy. These moves would benefit short-duration bonds as prices rise and yields decline to match the repricing of rate expectations.
Over the medium term, the fall in yield curves and energy markets is likely to support economic growth and growth-sensitive asset classes like equities. From a sector perspective, energy equities have been the main underperformer during the recent sell-off. The sector is looking attractive on the framework we use to assess opportunities, whereby we look at fundamentals, valuation and market price behavior. Basically, operating cash flows should be well underpinned by our constructive view on oil prices from these levels and from companies’ ability to cut operating expenditure and capital expenditure.
Valuations across all subsectors are also low relative to long-run history. From a market behavior standpoint, sentiment on oil and energy equities has grown extremely bearish. This is a contrarian positive. The sector is also extremely oversold, and positioning has lightened up a lot.
The other interesting potential short-term beneficiary in equities is the airline sector. We think the cyclical case is strong, given lower fuel costs and very attractive valuations. A lot of negative news headlines, such as pilot strikes and the outbreak of Ebola, have already been factored into the price. Structurally, however, there are concerns for the industry because of low returns on capital. Manufacturers of cars and tires are another potential beneficiary, but historical evidence argues against it. Mining, where energy is a key input cost, is also more attractive, and yet to take a more positive view on demand, we need more evidence.
In the short term, markets have reacted to the oil price falls as reflecting a weakening of demand and compounding the disinflationary forces that have taken hold in Europe. These short-term effects should give way to a view that emphasizes the supportive impact on growth of an effective tax cut for consumers. Moreover, a lack of inflationary pressure allows rates to be kept low, implying the continuation of a relatively attractive risk premium. The world remains characterized by widespread divergence, however, and we continue to emphasize the importance of being selective and to sizing positions appropriately.
Michael Spinks is co-head of multiasset, and Paul Carr is a portfolio manager, both at Investec Asset Management in London.
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