A welcome
shift in
sentiment

Luc Synaeghel, CIO 2016-03-11

Oil continues to be at the centre of our thought process, not just as regards asset allocation but also in terms of the global economic outlook. Its impressive price rebound since mid-February has made for much better oriented financial markets overall, with our (considerable) oil-related positions obviously receiving a particular boost. But the uptrend in the oil price, to the extent that it continues, also stands to alter the inflation picture, with direct implications for forthcoming central bank action.

We discuss the possible roots of the recent change in sentiment towards oil, which include the premises of an agreement between oil producing countries, potential for a faster-than-expected decline of US shale oil output, doubts about the true extent of current overproduction, and uncertainty as to Iran’s ability to rapidly achieve its targeted production. Extreme short positions were caught wrong-footed – their covering making the rally in the oil price all the more abrupt. Going forward, we continue to be bullish on oil fundamentals, anticipating that supply and demand may actually return to equilibrium sooner than the late 2016/early 2017 consensus. We put the next target at USD 60, which is the price level at which US shale production should really start to kick in again (some of the larger, lower cost, companies are admittedly likely to resume output around USD 40, but that will only serve to slow the overall rate of decline in shale oil production) – read more

Outside of the US and Germany, where tight labour markets could cause some upward pressure on overall prices, oil is really the only possible source of inflation. With all due respect to central banks, zero rates have not proved sufficient to enhance economic growth and generate even modest inflation. Pushing them (further) into negative territory would only serve to tighten credit conditions, hampering the economy. The only sure way for central banks to generate inflation would be outright debt monetization, but that would mean driving the financial system to its limits and risking large-scale destabilization. So what if the oil price were to rise to a “sweet spot” at which inflation approached the targeted rate, without fuel spending overburdening consumers’ budgets? Central banks would find themselves able to taper their quantitative easing (in Europe or Japan) or feel more comfortable raising rates (in the US) – read more.

While we do not foresee the Federal Reserve (Fed) hiking rates near term, largely for currency motives, we would thus not be surprised to see them act on a larger than expected scale later in the year. In other words, rather than gradual 25 basis points hikes each quarter, we could well experience some months of stability, followed by a couple of 50 basis points moves. In Europe, we must hope that if and when inflation does materialize, it is not too uneven across countries. Specifically, we must hope that price pressures in labour-tight Germany do not dwarf those of its partners, or the political stress on an already challenged European Union would be enormous.

OIL: THE STORY BEHIND THE RECENT REBOUND

At the mid-February USD 26 low in the oil price, short positioning had reached extreme levels, last seen in the midst of the 2008/2009 Great Recession. The unwinding of (part) of these positions explains why the ensuing oil price rally has been so abrupt – gaining more than 40% in the space of three weeks.

What drove the change in sentiment? The discussions between OPEC and Russia aimed at a production freeze were clearly an important catalyst. But we also see a number of other factors, starting with the outlook for US shale oil producers. The International Energy Agency (IEA) estimates that shale oil output will fall by some 500’000-600’000 barrels per day this year. We would argue that the actual decline might even be larger, to the extent that the hedges that sustained producers financially in 2015 have now run out (and new hedging is not an option when the price is below cost). Bankruptcies are thus looming, which stands to drastically alter the composition of the shale oil industry. Ultimately, its is likely that major oil companies end up holding a large part of the shale oil assets, making up both for their having missed out on the initial development phase and for their currently shrinking exploration budgets.

We would also express some doubts as regards published overproduction figures of 1.7 million barrels per day. If this were really the case, why are published stock levels not increasing proportionately? Inventories actually even contracted during the month of February. The IEA has a relatively good measure of oil supply, but uses demand estimates that are based on a GDP model per country. Not surprisingly then, oil demand is subject to periodic restatements. We would not be surprised to see that occur in the next months, bringing forward the timeline for the closing of the oil supply-demand gap.

Finally, we query Iran’s ability to rapidly drive oil output up to its 1 million barrels per day target. That the country will get there eventually is not a question. But the process of restarting production that has long been idle will require substantial investments, with the participation of foreign companies, and will take time. For 2016, an estimate of 500’000 barrels per day for Iranian production is perhaps more realistic.

All told, we expect the oil price to continue to recover, with a next target that we would put at USD 60. This is the level at which we would expect shale oil production growth to resume, but from a lower level and at a slower pace. Note that there is no single cost level for shale oil producers, but rather a continuum of cost levels ranging for USD 20 (in isolated cases) to USD 80. By putting production in much fewer – larger – hands, the likely transfer of ownership of shale assets to major companies alluded to above should make for greater discipline, with no turning on of production until the oil price is significantly higher.

Given this still positive outlook for oil, we stand firm on our existing holdings in the energy and related sectors (mining and shipping). These stocks have rebounded strongly from extremely depressed levels but we feel that their – valuation-driven – upside remains considerable.

THE RETURN OF (MODERATE) INFLATION

Right now, deflation is the prevalent concern – for both investors and central banks. As such, the pressure, in part self-inflicted, on ECB President Draghi to implement additional measures at the March 10 Governing Council meeting was enormous.

Option 1 was to prolong and/or widen the quantitative easing (QE) program. Last December’s experience showed that extending the duration of ECB asset purchases is of little relief to financial markets, being viewed as no more than another promise that can be altered whenever appropriate or necessary. Widening the scope of QE to other types of instruments, notably corporate bonds, might prove more “convincing” to investors, but could be difficult to implement due the lack of structure and narrowness of European corporate markets.

Option 2 was to push interest rates further into negative territory. In this case the challenge lies in how the banking system would respond, i.e. to what extent credit conditions would be tightened – certainly not a recipe for improved economic growth.

The outcome of the ECB meeting was in fact a mix of both options together with, and therein lay the surprise, a new long-term refinancing operation enabling banks to borrow at the (negative) deposit rate so long at they use the proceeds to extend credit to the real economy.

Ultimately, however, we would argue that, outside of an extreme (and dangerous) debt monetization scenario, it is not so much the ECB as the oil markets that could lift Europe out of its deflationary trap. Just as the fall in the oil price since the summer of 2014 drove down inflation measures, at the headline but also the core (ex-food and energy) level, its rebound could bring price indices closer to the ECB’s target.

With pressure to intervene then removed from the ECB, the Fed would also find itself freer to pursue its rate hikes, without risking excessive strengthening of the greenback. The important difference between the US and Europe (save Germany) lies in the labour market tightness. With the US unemployment rate now below 5%, wages are likely to compound the oil price effect on inflation data going forward.

This is not to say that the Fed needs to act immediately: at 2-2.5% wage growth is still below the 3% threshold said to be watched by the central bank. We thus envision a scenario in which Fed tightening takes not the form of a gradual series of small (25 basis points) hikes, but rather a period of inaction (buying time for Europe and avoiding a higher dollar) followed by steeper than anticipated rises. Admittedly this does entail a risk that the Fed “falls behind the curve”, but history shows that it has often tended to let inflation run. A 3% (or even 4%) inflation level would likely not spook the Fed – as well as help bring down government debt.