Macro Weekly – Major tailwind

by: Han de Jong

Macro Weekly 9 Jan 15 - Major tailwind ()

The global economy is growing, but at a relatively modest pace and everybody agrees growth is vulnerable and patchy. Nevertheless a gradual strengthening of momentum is expected. It seems to me that significant tailwind is currently developing. As a result, global economic growth is likely to exceed expectations. Just bear with me.

It is three prices, stupid!

A market economy is driven by relative price changes. I have followed and analysed economies for over thirty years. This is not based on any academic research, but in my experience the three most important prices in an advanced economy are the price of money as expressed in interest rates, the price of money as expressed in the exchange rate, and the oil price. Big swings in any of these prices have significant effects on the business cycle. My thesis is that many economies will benefit greatly in 2015 from significant movements in these prices.

Oil is overshooting

Oil prices are undoubtedly overshooting. It is inconceivable that prices of over USD 100 per barrel balanced supply and demand less than five months ago while it currently only takes a price of USD 50 to balance supply and demand. So what is going on? We think that prices of over USD100 were too high and reflected a premium for geopolitical risks. That premium proved unwarranted as supply actually rose. At the same time, forecasts for demand were lowered. As a result, the market started to correct. In the short term, an oil price fall tends to trigger a perverse supply response. Producers try to prop up their cash flow by pumping more oil. This only makes the excess supply problem worse. In addition, put-options are triggered as the correction continues, adding to supply. There can be little doubt that a range of producers are no longer economically viable and will cut production at some stage. But this takes a while. Also bear in mind the shape of the futures curve. A year ago, the curve was downward sloping. It is currently upward sloping. The price of future contracts, say two years ahead, has fallen much less than the spot price. The result probably is that explorations will fall by less than one would expect looking at the movement of the spot price. Having said that, exploration expenditure has already fallen by a material degree, judging by anecdotal evidence.

Is lower oil good or bad?

I think lower oil prices are very supportive of economic activity in advanced economies that are net importers of oil. But it takes a while to see the full effects. A big swing in oil prices produces winners (those using/consuming oil) and losers (the producers). Losers are often forced to respond quickly as they see an immediate fall in their cash flow. Winners tend to take a little while to realise what is happening and only spend their windfall after a while. Take recent German economic data. German exports have been weak recently, partly due to collapsing exports to Russia. Yet, German consumers have hardly started to use the increase in their spending power. But that will come.

There are some other negative effects following the sharp drop in oil prices. First, some countries will experience a significant financial squeeze and that may make them politically less stable. Russia, Iran and Iraq are perhaps the most obvious and important. An old Dutch proverb says that a cat in a tight corner makes unpredictable jumps.

Another negative effect is that a sharp correction of oil prices can increase uncertainty and, therefore, increase volatility on financial markets.

Who benefits?

Lower oil prices are simply bad for oil producers. Looking at countries, one has to say that it is bad for net oil exporters, while net importers are the winners. Although the US has increased oil production in recent years, the country is still a significant net importer. Western Europe and Japan are also net importers. The most important Asian emerging economies are also significant net importers. It is hard to calculate how large the stimulus will be to economic activity, particularly as it isn’t clear where the oil price will ultimately settle. It is, however, safe to assume that the impact will be meaningful but that it takes a while to materialise. The US economy was already growing at a pace above what we assume is its trend growth rate before the oil price came down. The additional stimulus will lead to a further gain in momentum as the year progresses.

Much lower borrowing costs almost everywhere

A year ago, ten year US Treasuries yielded almost 3.0% and they were expected to rise in the course of 2014. Today, these yields are around 2.0%. This has happened despite the fact that the US economy has grown at a relatively decent pace and despite the fact that the Fed slowed and later stopped its purchases of Treasuries. The fall in government bond yields has an impact on all borrowing costs throughout the economy. But this also involves lags. Then there is an additional lag between a fall in borrowing costs and economic activity.

The fall in bond yields over the last 12 months has been very pronounced in other countries as well. German ten-year government bond yields have fallen from almost 2.0% a year ago to around 0.5%. Spanish yields are currently 1.70% against 3.75% a year ago. Portuguese yields have fallen from 5.5% a year ago to 2.60% currently. UK yields are currently some 1.60% against almost 3.0% a year ago and even Japanese yields have fallen from some 70 bp early last year to some 25 bp now. It simply takes a while for this to have an impact on the real economy, but at the end of the day, this is a tremendously forceful impetus to economic activity.

Third: the exchange rate

Movements in exchange rates are, obviously, zero-sum games. Countries experiencing currency depreciation gain competitiveness, and vice versa. Having said that, I think it is fair to say that recent years have seen perverse currency moves. The eurozone economy has been one of the weaker economies, yet it often had the strongest currency. In my opinion, euro strength has done unnecessary damage to the eurozone economy. The picture is a lot healthier now. The strongest economy is seeing its currency move higher. This serves as a modest redistribution mechanism for global growth: away from the US, and to countries with weakening currencies. This does not improve the overall global growth performance, but makes for a more balanced distribution of growth and, as a result, makes the global economic recovery a little less patchy and less vulnerable.

Bear with me

It will take a while for these tailwinds to have their full impact. I feel confident that the global economy will perform well this year. Expectations are so low that it will be a piece of cake to beat them.