OPEC’s Calculus Gets Complicated

Next week, OPEC will hold what is arguably its most anticipated meeting so far this decade.

The slide in oil prices has brought out speculation about OPEC’s next moves.

What is becoming very clear is that until OPEC commits to support the market, price volatility will remain high. Our take is that Saudi Arabia is determined to enforce Cartel discipline, which suggests cartel action is only a matter of time. That said, with the emergence of U.S. shale oil production, OPEC is no longer the only marginal producer. This complicates OPEC’s strategy, because the tradeoff between lower production volume and oil-price gains is now less straightforward.

OPEC’s options range from shared production cuts to letting the current supply overhang force market clearing at a lower price. It is entirely possible the Cartel will fail to agree on production cuts, in which case oil prices could re-test recent lows of $78/bbl in Brent and $74/bbl in WTI with an eye toward a $60-per-barrel handle for both.

FOMC Downplays The Risks For Now

It was not a surprise that the FOMC described the amount of under-utilization in the labor market as “gradually falling”. Nonetheless, the Minutes were on the hawkish side for two main reasons.

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First, the comments played down the importance of dollar strength and recent growth disappointments outside the U.S. True, cheaper oil will provide an important offset to a more expensive currency in terms of economic growth, but it still seems complacent to downplay the impact of sluggish global demand on the U.S.

Second, the FOMC downplayed the plunge in long-term inflation expectations. Lower food and energy prices will of course depress headline inflation in the near term, but even forward measures of inflation expectations based on the CPI swaps market have fallen below levels that preceded QE2, QE3 and Operation Twist. Policymakers suggested that the shift could reflect a diminution in the inflation risk premium, rather than in inflation expectations themselves.

Nonetheless, the drop in forward inflation expectations has occurred against the backdrop of weakening commodity prices, dollar strength and downward revisions to global growth. It seems a stretch to argue that long-term inflation expectations were unaffected by this backdrop. Indeed, the University of Michigan consumer inflation expectations measure fell in November, which means that survey-based measures may not be as stable as the FOMC thinks. Even the Fed Staff project that actual inflation will remain below target for “the next few years”.

The Minutes revealed that FOMC will at least be “attentive” to evidence of a possible downward shift in longer-term inflation expectations because it “…would be even more worrisome if growth faltered.” This suggests that the Fed will be quick to lower the “dot plot” in the event of any growth disappointments.

Bottom Line: The FOMC has a greater tolerance for falling inflation expectations than we previously thought. The Minutes have given a green light to further dollar strength and modestly lower Treasury bond prices in the near term. These trends seem likely to continue until either growth disappoints, the equity market buckles or measures of long-term inflation expectations become intolerably low for policymakers.

U.S. Equity Sectors And The Soaring U.S. Dollar

The U.S. equity market is being forced to adjust to a surging U.S. dollar. There will be winners and losers.

The U.S. dollar has climbed to its highest level in more than four years, coincident with a sharp decline in global inflation expectations and sub-par foreign economic activity. This is a reversal of the post-Great Recession backdrop, when steady U.S. dollar depreciation, along with ultra-easy monetary policy and subdued but consistently positive global economic growth, turbo-charged corporate sector profit performance.

According to Standard & Poor’s, 46% of total sales are generated outside the U.S. Emerging markets matter more than the euro area , at 16% and 11% of revenue, respectively. Unsurprisingly, the impact of a rising dollar is not uniform across sectors within the U.S. equity market. The challenge for investors is to weigh the negative profit impact against the potential for a valuation/investor preference trade-off that might trump earnings performance. Our U.S. equity sectors team has analyzed the impact of the rising dollar on the ten U.S. S&P 500 sectors.

Euro And The Stock Market

Unlike other major currencies, the euro has a strong and persistent positive correlation with the domestic stock market.

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For Japan, the U.S. and the U.K., the correlation between the stock market and the currency has tended to be negative (or at least not positive). In an era when a main aim of central bank policy is to drive up asset prices, this is significant – because the negative correlations mean that higher asset prices are entirely consistent with a weaker currency.

However, in the euro area the correlation between the stock market and the currency has been consistently and strongly positive. Therefore, while the ECB’s monetary loosening may initially weaken the euro, if it also lifts asset prices, the second-round impact works in the opposite direction. It strengthens the euro. In effect, the euro is caught in this tug-of-war which constrains a permanent move.

According to European strategists, the implication of the above is that a full-scale QE in the euro area might not have a lasting downward impact on the euro. Also, such QE in itself is unlikely to change banks’ all-important lending behavior. More important for bank lending is the recent publication of the stress test results – as it has diminished a major incentive for euro area banks to aggressively shrink their balance sheets.

Euro Area: Potential For Upside Surprise?

Recent client visits uncovered that investors are uniformly bearish on Europe. What could go right?

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We offer two potential candidates for upside surprises in Europe:

  • European banks have been hesitant to lend ever since the AQR/stress-test exercise was announced at the end of 2012. Our view is that most banks will likely pass the test (results are expected at the end of this month), largely because of the severe deleveraging undertaken throughout late 2013. This would relieve a serious constraint on the supply of credit and risk assets should benefit.
  • At present, there is a small projected fiscal drag for the euro-zone next year, but the most likely outcome is that this is reversed. Our geopolitical strategists remain convinced that Europe is slowly developing a consensus around the quid pro quo of structural reforms in exchange for the end of austerity. The current pace of fiscal consolidation is simply politically unsustainable, as recent Pew polls clearly illustrate.

Bottom Line: Extreme bearishness on Europe invites a contrarian stance and suggests that any slight policy surprise could cause a positive reaction in euro area equities. Stay tuned.