Friday, January 16, 2015

Cheaper oil is fantastic news

While markets continue to fret that plunging crude oil prices threaten to devastate the oil industry and thus weaken the economy, consumers are rejoicing. Freed from the burden of very expensive gasoline, consumer confidence has surged to levels not seen (on a sustained basis) in almost 15 years. This recovery has been the weakest ever and the most risk-averse, while confidence has been in short supply. Now, cheaper oil is sparking a significant and much-needed change for the better. Confidence is making a comeback, and with that we are likely to see further declines in risk aversion, more investment, and more work. The economy is thus likely to outperform expectations going forward, and this should be good news for the equity market.

In the past few months, consumer confidence has surged after being depressed for years. Confidence is now comfortably above its long-term average, and back to levels last seen (with the exception of January 2004) in the year 2000.

At the same time, real crude oil prices have plunged, and are now somewhat below their long-term average. With the exception of the brief and mild recession of 2001, every other recession was preceded and accompanied by a spike in real crude oil prices. Could the cost of energy and confidence be related? You bet. Check out the following chart: 

The chart above compares the inverse of real crude prices to the same measure of consumer confidence shown in the first chart on this post. Cheaper energy invariably goes hand in hand with rising confidence, and more expensive energy usually accompanies falling confidence. This strongly suggests that the extremely expensive level of crude prices that persisted throughout most of the current recovery was a significant headwind to confidence and growth. That headwind has suddenly become a tailwind.

In other news today, the Consumer Price Index in December fell 0.4%, as expected, and it was mostly due to falling energy prices. The core measure of consumer price inflation was unchanged for the month, and it was up 1.6% for the year.

The chart above plots the level of the core CPI on a semi-log scale, to show that core prices have been increasing at a 2% annual rate, on average, for the past 12 years. Deflation (outside of the energy sector) isn't anywhere on the horizon, and even if it were, it's not something to worry about, especially when confidence is surging.

Actually, deflation is alive and well in the computer industry, as the chart above shows (but deflation in one sector of the economy is very different from overall deflation). For the past 15 years, prices of personal computers and peripherals have been falling at the rate of 8% per year. From 2004 through 2009, prices fell about 13% per year, and from 1998 through 2003, prices fell by an astounding 25% per year. Did this wreck the personal computer industry? No. It was all part of a revolution in technology that has empowered consumers beyond their wildest dreams. Think of the magic of GoPro, the staggering power and convenience of smart phones, the ability to carry thousands of record albums and tens of thousands of photos in the palm of your hand, and the ability to film, edit, and watch high-definition movies for hundreds instead of hundreds of thousands of dollars. 

To borrow from Ralph Waldo Emerson, worrying about deflation is the hobgoblin of little minds. 


Tyler Nation said...

Hi Scott,

Another great post. It's refreshing to hear a view based on numbers and reason in regards to the current drop in oil prices.

Taking a step back to your post on 2015 predictions. You mentioned that you're high on both REITs and Total Stock Market/S&P500 for 2015. If you were in my shoes as a 29 year old (i.e. long investing horizon) and you were looking to max your 401k as of today for the 2015 year. Would you go all REIT Index, all Total Stock Market/S&P Index, Combo of the 3? Since your post (Dec 31) REITs have jumped by 7%.

Thank you for any insight that you can share.



Benjamin Cole said...

I am a hobgoblin with a little mind!