“If you are going to use probability to model a financial market, you had better use the right kind of probability. Real markets are wild. Their price fluctuations can be hair-raising—far greater and more damaging than the mild variations of orthodox finance.”
Benoit Mandelbrot, The Misbehavior of Markets
Commentary & Analysis
Oil $10 per barrel—Are you nuts?Not if stocks help the process along..
The news concerning China’s decision to devalue its currency could have broad implications for the global economy. The key question is will stocks wake to the reality of the growing disconnect between the financial and real economy—has the valuation rubber-band stretched far enough?
Today’s devaluation comes on the heels of the Chinese being iced out by the International Monetary Fund for inclusion of its currency—the yuan—into that” all important” basket bundled by the IMF call Special Drawing Rights (who even has a clue what that stuff is or used for). So, instead of global reserve managers having to shift a wole bunch of captial into the yuan, we may witness a whole bunch of portfolio managers shifing a whole bunch of capital out of China. Can you say hot money flow to the US dollar via US Treasuries to hide? 30-year Treasury futures jumped a whopping 2 points today, i.e. long bond yields fell.
Today’s action by the Chinese seems a bit of capitulation on their part to the powerful deflationary forces eating away at them—overcapacity (read malinvestment), tepid global demand and rising debt (with all its juicy feedback loop growth crushing implications) are not what keeps hundreds of millions of Chinese people fully employed. Of course the mere mention of China problems leads to thinking about commodities; and commodity currencies. Given the battering commodities have already seen (the Thomson Reuters Commodities index has made a round trip since the central banks started stimulating in an effort to help the real economy), the question is can the major commodities, thinking primarily industrial metals and energy, go much lower?
The short answer is yes.
The real economy continues to get whacked realtive to the financial side. Today’s announcement by China, relatively more dependent on the real economy, is an exclamation point on the massive disconnect between the fiancial and real economy.
Yesterday a friend sent me a private global macro newsletter written by a man who has been doing this stuff for over sixty years at his own invest ment firm. This advistor said he is expecting it all to end in calamity—and soon.
He believes stocks are close to a supercycle top, evidenced by massive distribution of stock by insiders for the last few years and his own form of wave analysis applied over a very long timeframe (I do not have permission to share his charts unfortuantely). For grins, I have taken the cash S&P 500 index monthly chart measured from the 1987 crash low (the end of the world as we knew it at the time; at least for the mortals such as me) and counted up in an A-B-C pattern. Wave C is slightly longer than A, which targeted to 2,056 (I am not pretending any validity here, just playing with charts; but it gives you a clear indication of just how massive this rally has been since the central banks got busy after the credit crunch in 2008). Is there any doubt after viewing this chart where most of the money and credit created globally went?
My investment advisor friend thinks oil will visit the $10 per barrel level before this is over (back to the mid-1980’s prices); a fresh new low in oil today by the way. Is he nuts?
$10 oil seems extreme, but there is a lot of air between $43 and $10 even though there has already been massive damage to the sector since those heydays of Peak Oil worship when black gold hovered near $150 per barrel (all the cheerleaders for Peak Oil promised us that $200 oil was here to stay). If China leaves the building, oil could go a lot lower.
The reason China is so important for oil prices at this juncture is because it doesn’t seem the US “recovery” is quite strong enough to pull the global wagon alone. From Russ Koesterich, global chief investment strategist at BlackRock, writing in the Financial Times recently:
Even if you optimistically assume some acceleration in borrowing as income growth rises, an older, more indebted consumer is unlikely to borrow at the same rate as pre-crisis. Assuming the pace of household debt accumulation converges to a level consistent with nominal income growth, this alone would suggest a 1 percentage point reduction in the rate of household spending relative to the historical average.
The obvious way out of this dilemma is faster income growth. Not surprisingly, income growth has historically been the single largest driver of changes in consumption. Looking at 20 years of US retail sales data, the year-over-year change in personal income explains roughly 50 per cent of the variation in retail sales growth. The challenge is that a sustained acceleration in income growth is unlikely without stronger productivity. Unfortunately, the latter is either proving elusive or, at the very least, more difficult to measure in today’s service-driven economy.
Without higher productivity, investors probably need to lower their expectations of what the US consumer can deliver. To paraphrase Mark Twain, rumours of the rude health of the US consumer may have been somewhat exaggerated.
In short, if the US consumer can’t do it, there isn’t anyone left who can trigger an uptick in global demand. And all those cash flows supporting stock prices will likely start to wilt under the pressure of falling top-line growth.
I realize even verbalizing the idea of $10 oil prices means thinking about a massive global deflatonary scenario—great depression type of stuff.
This fear may seems the justifiction for central banks to keep on doing what they are doing in an effort to keep hope alive.
But if the stock guys get spooked by China the rationale of the massive financial-to-real economy disconnect may become the new investment theme instead of the don’t fight the Fed theme. Of course Chinese concerns have been in the market for a while and it hasn’t seemed a big deal. But today’s devaluation adds a layer of complexity. Will central banks now backtrack on rate threats? Will emerging market currencies get hammered more on the back of Chinese export competition al la a lower currency? If China does export more, is it only stealing demand from other Asian competitors? Will Chinese regulators clampdown on captial flowing out of China? Will the Chinese stock market benefit from today’s action given Chinese stocks look a bit cheaper in yuan terms? Will further official devaluation trigger trader tarriffs? Will the Japanese yen rise in value on repatriaton flow?
How perfect would it be if Warren Buffet’s biggest acquisition to date—announced yesterday—is the bell ringing at the top?
As I have talked about many times before in these pages, the stock market is a massive repository of real economy collateral value (on which many $’s worth of lending depends); thus a fall in stocks will have in a direct and immediate negative feedback loop into an already relatively weak real economy. Part of the financial bubble game was triggering the positive feedback of the “wealth effect.” That is what central banks were counting on when they became stock market cheerleaders instead of boring central bankers.
I am not arguing all the juice into financial assets hasn’t had some residual benefit for the real economy—it certainly has. But I believe its fair to say the impact hasn’t been as expected given the historical weakness of the current so-called recovery. It seems to me the balance sheet recession is alive and well and financial repression isn’t the way to set the stage for fresh growth especially given the world lurched from overleveraged—the credit crunch—to even more over leveraged thanks to QE.
The negative feedback loop of falling stocks in a world of extremely tepid global demand might just make the crazy idea of $10 oil a lot less crazy sounding. Stay tuned.