Here’s a question a lot of people are asking on Monday:
Should I give a shit about plunging crude prices?
You’d think the answer to that for most investors would be “yes.” And unequivocally so.
But that may not be entirely accurate.
Because when you think about it, the reason oil careened into a bear market last week has more to do with sentiment around supply than it does with sentiment around demand. That matters.
Sure, plunging oil prices don’t bode well in an environment characterized by an already fading inflationary impulse, but if supply is the problem, there are things we can do to “correct” the situation.
If, however, it’s a demand problem, well then we’ve got a real fucking issue on our hands because what have central banks been doing these last eight years if not trying to reflate the global economy/boost aggregate demand by flooding the market with tens of trillions in liquidity?
So if it’s a demand issue, then that sends a worrying signal about the future of the global economy thus casting doubt on the sustainability of the rally in some risk assets (like say, stocks).
Well as it turns out, BofAML has a note out on Monday that takes up this issue on the way to lambasting “stubbornly hawkish” policymakers in the US and China who the bank thinks may be trying to plunge the world into a deflationary death spiral. Read a few notable excerpts below…
Via BofAML
Supply news has dominated the oil market narrative…
A key issue for financial markets is whether the substantial sell-off in oil prices could begin to have knock-on effects beyond markets directly exposed to oil price swings. As ever, the underlying driver of lower oil prices matters: supply-driven declines typically have less impact on broader risk assets than negative demand shocks. The former has been the narrative so far with higher OPEC output driven by Libya and non-OPEC output driven by the US being the proximate driver of weaker oil. It should therefore be no surprise that equity markets have held up reasonably well.
… but watch red flags for oil demand
However, our commodities team warns of emerging red flags for oil demand, which at a global level is running at just half the growth rate of the last two years. Looking into 2H17, they now doubt that demand growth will accelerate sufficiently and see downside risks to our forecasts of 1.3 million b/d in both 2H17 and 2018. The tighter policy bias in the US and China against a backdrop of weaker data adds to the downside risk to oil demand and prices. Spillover risks would heighten against this backdrop.
A simple measure to distinguish supply vs. demand driven oil market
The dynamic described above allows us to isolate oil price shocks that are driven by supply or demand factors by looking at the corresponding movement in global equities. Chart 1 shows the six-month rolling correlation between weekly returns of global equities and oil. The negative correlation observed year-to-date is consistent with the supply-focused narrative around oil prices. But it is also notable that the average correlation over the sample is positive, underlining the longer-term dominance of demand drivers, at least based on this simple correlation proxy.
The bad news, as tipped in those passages, is that rising real rates combined with a flattening yield curve represents a stumbling block for demand:
Yet, unfazed by the roll-over in activity and inflation and lower growth expectations, the Fed and the PBOC are sticking to a stubbornly hawkish path. Tighter money at a time of weaker activity poses deflationary risks and a spill-over into the real economy.
Demand is the main transmission channel for this effect. We find that global oil consumption growth tends to be lower at times of rising US real rates and a flattening yield curve. Thus, the tighter policy bias in both the US and China against a backdrop of weaker data poses downside risks to oil demand and prices.
BofAML’s conclusion: “A hawkish Fed and PBOC that ignore the rising real rate environment could further exacerbate the recent drop in commodity prices.”
But this is a chicken-egg scenario. A Fed that isn’t stubbornly hawkish risks allowing asset bubbles to inflate further by keeping financial conditions far too loose.
So it would appear they have a choice: prick the bubbles at the risk of pushing the economy into recession, or allow the bubbles to inflate even further and risk another spectacular collapse down the road.
A bit of a Sophie’s choice.
*****
