Financial markets hostage to what happens to the oil price
Asset classes have reacted quite differently to the nosedive in oil prices in recent weeks. Consumer and cyclical shares in the developed world have been buoyed by the boost to their earnings growth momentum.
Shares and bonds of companies producing and refining oil have come under the cosh. Spreads on corporate bonds issued by groups in these sectors have been stretching wider, as have spreads on sovereign debt from oil- producing nations like Russia or Brazil.
Asset classes reacting in contrasting ways
The slump in the price of crude oil has blown hot and cold through financial markets depending on the asset class involved. For instance, cyclical and consumer shares traded on markets in advanced economies have been bolstered by the improved dynamics underpinning prospective earnings growth whereas the squeeze on profit margins of companies producing and refining oil has penalised their shares. Moreover, spreads on bonds issued by oil- industry groups or sovereign debt of emerging countries heavily reliant on their exports of oil have been widening, giving rise to a new risk factor on international markets – one with the potential to exert a systemic impact on account of the domino effect it could detonate. As we outlined in our ‘Macroeconomics’ article, the plunge in oil prices has ratcheted up deflationary pressures threatening the eurozone. Considering the prospect of liquidity being pumped wholesale into the system as the ECB embarks on quantitative easing appears to be nearer to hand than previously thought, eurozone interest rates may well remain under pressure. In a world of very subdued inflation, the gold price is also likely to remain at half-mast, especially considering the US dollar can be expected to make further steady progress throughout 2015 as the US macroeconomic regime shifts from monetary-policy-driven to a more fundamentals-influenced mode.
Corporate profits still making dispiriting reading in Europe
Stock markets in advanced nations proved particularly energetic in November as they recovered from their discomforts in October. Gains in the month, with dividends reinvested, worked out at 2.7% for the S&P 500, 3.3% for the STOXX Europe 600 and 12.7% for the TOPIX. Even after a decent November, European shares are still trailing around 5 percentage points behind US equities in terms of their year-to- date track record after already under-performing by almost 11 points in 2013.
Third-quarter company results came in slightly ahead of expectations in both the US and Europe. However, the better US numbers were solely driven by the contribution from financials, and this final quarter of the year has been the least dynamic for 18 months. Profits were also driven higher in Europe by the financial sector. The more encouraging results in the third quarter were chiefly influenced by a favourable base effect as profit forecasts had been heavily downgraded over the course of 2014. Roughly 8%-9% of earnings projected for 2014 and 2015 have evaporated into thin air since January.
Yen on the slide, Japanese shares on the up
The correlation between movements in the yen and the TOPIX index has tightened further in the second half of this year. Major Japanese companies benefit directly from a weakening yen, either because it sharpens the competitive trading edge of their exports or because it boosts the yen value of earnings repatriated from profits generated overseas. As a result, Japan has been the only market which has continued to enjoy earnings upgrades for 2014 and 2015. The Bank of Japan’s latest round of quantitative easing, announced in late October, is hardly likely to change this direction. The ongoing close correlation does, however, highlight the importance for foreign investors in Japan of hedging their exposures to the yen.
Emerging markets lagging behind
For now, the valuation of emerging markets is not providing any factor of support to boost their performance. Shares in the emerging world have experienced mixed fortunes over the course of the year. At the extremes, we find Russia where shares, as measured by the RTSI in US dollars, have crumbled by almost 30% and India where the Mumbai market has raced up by nearly 38%. All in all, the MSCI Emerging Markets index, expressed in US dollars, has put on 2.9% in the year to end-November, noticeably less than the MSCI World’s 7.2% gain. If we look at Asian markets excluding Japan, earnings trends, just as they have in Europe, are still heading in the wrong direction. Projections for earnings growth in 2014 and 2015 have been downgraded by between 9% and 10% this year.
Strong dollar, weak emerging-economy currencies
The robust US economy and the Fed’s start on tightening monetary screws again should lend the dollar sturdy support in 2015. This momentum should be sustained, especially against most currencies in the emerging world as their exchange rates, being sensitive to capital flows, will be influenced by the Fed’s monetary-policy decisions.
The dollar should also firm in 2015 against most advanced-economy currencies although this will not preclude the odd deviation from the overriding long-term uptrend during the course of the year. When it comes to the euro, the difference between central banks’ balance sheets does already appear to have been priced into the exchange rate, but the same is not true for the gap in economic growth rates. If, as we are expecting, the US economy cruises along at a steady 3% and the eurozone continues to bump along at close to zero, then an exchange rate of USD1.15 to the euro cannot be ruled out as a possibility. We are looking at USD1.20 to one euro as the next threshold level in the early part of 2015.
Tumbling oil price helping the global economy out
The price of crude oil plummeted by around USD25 a barrel between June and November under the impact of temporary overproduction and a strengthening dollar. At its meeting in the last week of November, OPEC decided not to step in and left market forces to dictate the level for the oil price, triggering a further USD10 drop before the price levelled out at USD72. In our view, the price has overshot on the downside and we would expect it to clamber back upwards, albeit quite gradually. If OPEC countries are happy not to reduce their output of oil, its price level will hinge on demand which we do not see quickening noticeably in 2015. In light of recent developments, we have lowered our forecast for the average price of oil in 2015 to around USD95/barrel, with the likelihood the price will stay quite low in the early part of the year before climbing in the second half.