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.