Tuesday, August 16, 2016

The oil slump has passed

The collapse of oil prices that began about two years ago—from just over $100/bbl to just under $30/bbl—threw a wrench into the gears of the US economy by causing a sharp drop in oil exploration and drilling-related activity. In turn, this resulted in a slump in industrial production and a rash of layoffs, all of which subtracted meaningfully from the health of the US economy. The impact of the oil patch slump was most acute last February, when spreads on high-yield energy bonds soared to almost 2000 bps—a level matched only during the depths of the 2008 financial panic. From the beginning of the US economic recovery in mid-2009 through the third quarter of 2014, just before oil prices started to plunge, the economy grew at a 2.25% annualized rate. From September 2014 through last June, the economy grew at only a 1.7% annualized rate. Arguably, the oil price collapse subtracted half a percentage point of growth per year from the US economy for almost two years.

It now appears that the negative effects of the oil price collapse have passed. Drilling activity appears to have recovered in recent months, and oil prices have bounced from just under $30/bbl to almost $47/bbl today. High-yield energy bond spreads are back down to 740 bps, and the S&P 500 index is up almost 20% since mid-February. The ISM indices have bounced reassurringly.

What awaits us is the boost to economic activity that is likely to be fueled by cheaper and more stable energy prices. The market may already be sensing this, in fact, as equity prices probe new all-time highs, and as Treasury yields bounce off their all-time lows of last month. The significant bounce in recent months in the Chemicals Activity Barometer that I noted recently is an excellent indicator of improvement.

Here are some charts that tell the tale:


The chart above shows the collapse of oil futures prices and their more recent bounce, which equates to more than 50% since last February's lows.


The chart above shows the Baker Hughes US Active Rig Count. It suffered a monumental collapse of 80% over the course of 18 months, but it has bounced 25% in the past 2-3 months, following the bounce in oil prices.


The chart above shows the spreads on HY corporate bonds. The peak stress in the oil patch almost matched the never-before-seen peak in HY spreads in late 2008, when the market feared catastrophic default rates. '


Beginning in early 2104, US industrial production suffered its biggest non-recessionary slump, driven mainly by a sharp, 15% decline in mining activity. Today's release of July production data was much stronger than expected (0.7% vs. 0.3%), and it appears to mark the end of the industrial production slump; mining activity has now been flat to slightly up for the past three months. 



The July ISM manufacturing report confirms that conditions in the manufacturing sector have improved meaningfully in recent months. As the chart above suggests, the current level of the ISM index is pointing towards a moderate acceleration in real GDP in the current quarter. 


The chart above compares the level of the S&P 500 to the ratio of the Vix Index to the 10-yr Treasury yield. Equity prices have rallied significantly since the February low in oil prices. The Vix index has dropped considerably over the same period, but at 1.57%, the 10-yr Treasury yield is still very low. The market senses some improvement in the economy on the margin, but there is still a considerable amount of skepticism in regards to whether we are likely to see a meaningful pickup in economic activity. I think the market is too pessimistic.

Having successfully navigated the oil price collapse storm, it is not unreasonable for the Fed to be hinting at a sooner-than-expected hike in rates (I refer to Dudley's comments this morning that the market is underestimating the likelihood of a September rate hike).

One thing to keep in mind: since lower interest rates haven't boosted growth, why should higher rates be a threat to growth? The answer is simple: the Fed hasn't moved rates proactively. The Fed has been and continues to be a follower—guiding interest rates lower as the economy weakens, and higher as the economy strengthens. The market is too fearful of a rate hike, in my opinion.

If our future president would only take this WSJ op-ed to heart ("The Cure for Wage Stagnation" by Hassett and Mathur) and slash corporate tax rates, we could see an economic boom of significant proportions in the years to come. Excerpts:

More productive workers earn higher wages. Workers become more productive when they acquire better skills or have better tools. Lower corporate rates create the right incentives for firms to give workers better tools. 
... the corporate tax is for the most part paid by workers. 
Wage growth will continue to be disappointing as long as the U.S. has the world’s highest corporate tax rate. Denying the need for lower corporate rates may be effective populism, but it is causing real harm to America’s workers.

13 comments:

marcusbalbus said...
This comment has been removed by a blog administrator.
Matthew Grech said...

Marcus, honestly, did you even read the post?

mmanagedaccounts said...

Marcus is so intelligent and insightful he should write his own post which nobody would bother reading. Really----he reveals his ignorance, and, sadly, he thinks he's smart!

Benjamin Cole said...

Oil may rise in H2 but the buzz seems to be that is due to a possible artificial OPEC production ceiling. If no ceiling then maybe no increase in oil prices.

This post puzzles me. I think lower oil prices are good and associated with higher economic growth.

The argument that domestic production of oil is a positive for the US economy is interesting, and could be applied to all manufacturing. Did I hear Don Trump?

I would like cuts in corporate income taxes. To boost employment, perhaps cuts in FICA taxes would work better.

Globally, many major economies are in deflation or close and capital is so abundant that people pay for the privilege of owning a safe IOU.

Seems like globalist central banks have obtained their no-inflation nirvana. Ain't it grand?.

Hans said...

Spot on, as they would say, Ben Jamin. I am projecting goo
to rise to the 52 to 55 level. And yes, as Ben stated the
advance is due to OPEC's suggestion of reducing production.

There has been over the past year, writers and economists
suggesting how bad the failing goo prices have been on the
economy? Are these esteemed thinkers for real? If this is
indeed the case, then we should ban ALL imports from Red
China as well.

Corporate taxes should go to .oooo1 and FICA for those entering
the work force (18 to 28 of age) should be eliminated.

The marketplace needs incentives and not disincentives.

Marcause, our next QE Czar!

Lawyer in NJ said...

Hillary and Ryan would be able to reach sane comprises without exposing the country to an unstable Orange fool.

Scott Grannis said...

A reprise of the Bill Clinton/Newt Gingrich era would be a great outcome, but Hillary is not Bill. Bill has lots of political savvy; Hillary does not.

Benjamin Cole said...

"Over the past 5 months, however, while shelter inflation has remained above 3%, core CPI excluding shelter has increased by only about 0.3%.  That's about 0.73% annualized."

The above from Idiosyncratic Whisk.

Fascinating. Without property zoning there would hardly be any inlation, as measured. Also, zoning probably feeds into inflation through higher wages, and so forth.

So why the constant drumbeat at the Fed for tighter money, always and everywhere?

Property zoning is the largest structural impediment to growth in America today.

Scott Grannis said...

I'm not sure the numbers you cite are correct. Owners Equivalent Rent, which has increased at a 3.5% annualized rate in the past six months, represents about 25% of the Core CPI, which has increased at a 2.0% annualized rate in the past six months. That implies that Core CPI excluding shelter increased at about a 1.5% annualized rate in the past six months.

Excluding the cost of housing from a calculation of inflation may be a bridge too far for most people. And assuming that housing inflation is exclusively driven by zoning laws is a leap of faith. Only portions of the massive US housing market reside in areas with restrictive zoning.

But for the sake of argument let's assume that zoning has artificially inflated the cost of housing. Is this inflationary? No. If the Fed is doing its job—which is to control the overall purchasing power of the dollar—then any attempts to artificially inflate one category of consumer spending must necessarily deflate another. If you have to pay more for a house you have less money to spend on something else. Lots of people every day leave expensive California for cheaper housing in other states, by the way.

Bottom line, you can't exclude housing costs from inflation and you can't blame inflation on zoning laws. Inflation is a monetary phenomenon, not a zoning phenomenon.

Benjamin Cole said...

Good points Scott.

I still would like free markets, not government zoning boards, determine land use.

Benjamin Cole said...

"The final reading of July Eurozone consumer prices recorded a 0.6% monthly decline, which was slightly larger than the 0.5% expected, although the annual rate was confirmed at 0.2% from 0.1% previously, unchanged from the rate seen in July 2015. Although expected, the ECB will remain uneasy over underlying inflation trends.--economiccalendar

So, deflation in Europe, Japan.

China does have minor inflation (below 2%), though more than 50 months straight falls in producer prices.

The U.S., on the PCE core is at 1.65% YOY.

Time will tell, but I am just not feeling the inflation problem right now…growth is very sluggish tho….


Kevin Erdmann said...

Scott,

My measure of shelter and non-shelter CPI has been based on the larger "shelter" component, which includes owner-equivalent rent, tenant rent, and a few other things, so it is closer to 40% of the total core. Tenant rent has been running a little higher than OE rent. There is a BLS measure "CPI less food energy and shelter", which is at about 1.4% now.

I would suggest that for a number of reasons, shelter inflation is measuring a transfer of income being claimed as economic rents by owners of properties where capital investment is repressed. It is not measuring monetary inflation. But, in the most simple terms, owner equivalent rent is not monetary because it doesn't utilize money. It is imputed.

marcusbalbus said...

this is trite nonsense