Investment Clock insights

Cheaper oil 12 months on

Ian Kernohan

18 December 2015

12 months on from the major slide in the price of oil, and with the price falling again in recent weeks, it seems a good time to take stock of the impact on the global economy and markets. Global recessions have often been preceded by a sharp increase in the oil price, as this acts as a constraint on household and corporate demand.  By contrast, large falls have tended to be followed by stronger global growth.  Macroeconomic models suggest that the boost takes place with a lag of about one year, as firms and households come to believe that the fall will be sustained.  Cheaper energy acts like a tax cut for consumers and many corporates, by reducing the prices of transportation and other energy dependent goods and services.   

So much for the theory, what about reality? To date, the sharp fall in the price of oil has created a lot of 'bad news': it hit the manufacturing sector via a sharp fall in oil related capex, damaged public finances in oil producing states with relatively young and restless populations, and driven headline inflation into negative territory.  There have also been fears that cheap oil will trigger a financial tsunami, followed by global recession, as a result of debt default contagion from high yield corporate debt. There is less evidence that cheaper oil has given a major boost to the global economy, although global growth may have been even weaker without it.  We expect the focus to shift towards the winners from cheaper energy and away from losers during 2016.

What matters is not just that the oil price has fallen, but why it has fallen.  Supply driven falls tend to create a more benign scenario of 'good disinflation', which boosts real incomes, while demand led falls are evidence of significant slowdown in the global economy.  While some of the recent fall reflects lower expected oil demand in emerging economies, most reflects higher expected oil supply, and a long period of overinvestment in production which needs to be worked through. 

The US is an important test case for the positive impact of cheaper oil, since it is both a major producer and consumer.  A low oil price has squeezed oil production here and had a knock on effect to manufacturing. However, the effect on the overall economy should be offset by the boost to household demand and non-energy US PLC.  Despite the hit to shale oil and the stronger dollar, employment and real incomes are rising, while the latest GDP figures show consumer spending +3.2% year on year (yoy), residential investment + 9.2%yoy and total fixed investment +3.6% yoy. 

Assuming the focus  shifts from oil losers to winners, how should investors be positioned?  Equity markets in the major oil importing regions, such as Europe and Japan should continue to do well. Consumers in these regions should benefit from the 'tax cut' effect, as should companies which are intensive users of oil.  US consumers should also benefit, however with the US Federal Reserve (Fed) set to raise interest rates further, this should curtail the performance of consumer related sectors within the equity market.  Companies dependent on the oil sector, either as producers, or as manufacturers of oil equipment, will continue to come under pressure, until there are clearer signs that the oil price has stabilised. 

The value of your investment and the income from it is not guaranteed and can fall as well as rise. This article is for professional customers only. The views expressed are the author’s own and do not constitute investment advice.