Around the middle of last year, we pointed out that:
“the recent shift in crowd sentiment suggest[s] this could be the start of a more sustained rally in crude oil prices.”
Given crude oil prices had spent the first half of last year drifting lower, it was far from obvious that the second half would be more favourable. However, a notable drop in future net supply sentiment by the crowd was a clear indication to us that expectations of the underlying fundamentals in the crude oil market were shifting in favour of rising prices – see exhibit below. Since then, the price of WTI has risen from USD 49 p/b to around USD 64 p/b – a gain of just under 30%. Not quite Bitcoin-like returns, but nonetheless not bad.
The Crude Oil Price Story
Exhibit 1: Crowd-Sourced Sentiment Vs. Price – Crude Oil
Although at that time we concluded it was unlikely, we did not entirely dismiss the possibility that a sustained rise in the crude oil price would add to investors’ growing list of worries about the sustainability of the bull market in global asset prices.
Some six months later, and with crude oil prices (and global equities) significantly higher, these worries are starting to creep to the surface.
The reason is not so much the level of the crude oil price – USD 64 p/b is not particularly high compared with the price range crude oil has been trading in over the past decade – see exhibit below. Rather it relates to the speed and magnitude of the move.
Exhibit 2: Crude Oil Price – Level and Y/Y Changes
Barring a significant and swift reversal, a rise in the price of what is still a key input commodity means a positive impulse in headline CPI inflation is largely “baked into the cake” for 2018 because of the base effect. (Assuming crude oil stabilizes for the rest of the year at current prices the y/y change will rise to almost 50% by June).
Faced with an uptick in inflation, the worry is that the world’s leading central banks, already in the process of withdrawing monetary stimulus, may accelerate the pace of policy normalization. With many investors believing a low risk-free rate (not a phrase we like but everyone knows what we are referring to) has been a key factor underpinning global asset prices, it does not take too much imagination to see the downside risk – the rally gets corrupted, derailed or reversed.
As Davies points out in the aforementioned blog post (see above), what is critical is whether the 2018 bump in headline CPI inflation is transitory or something more sustained – an argument we also made last July.
Central bankers have learned from experience that it is appropriate to look through transitory rises in headline inflation partly because often there is not much that they can do via monetary policy to offset the effect and partly because it would create unnecessary volatility. Only when the inflationary effect of rising oil prices threatens to become more entrenched – so-called second-round effects – is a monetary response deemed appropriate.
Looking at how future inflation sentiment, our crowd-sourced proxy for expected inflation, has evolved over the past six months, there has been a tick up in numerous countries – more so in developing than developed. (In the exhibit below, the numbers in the outermost circle denote the change in sentiment over the last six months – green denotes a positive change while red denotes a negative change.) However, the rise has been limited in magnitude such that, in absolute terms, future inflation sentiment remains modest. Certainly, it cannot be considered extreme.
Exhibit 3: Crowd-sourced Sentiment – Future Inflation
Such readings suggest that, even taking into consideration the impact from the rally in crude oil prices, the crowd is not anticipating a significant rise in inflation rates. To borrow the lexicon of central bankers, inflation expectations remain “well-anchored”.
The situation would, of course, change in the event that the rise in crude oil prices persists. This is a risk, certainly. Yet, looking at how things stand at present, if anything, the upward trend in the crude oil price appears vulnerable.
What Does the Crowd Think?
Crowd expectations about net crude oil supply have continued to fall, hitting levels not seen since the 2014-15 crash. Concomitant with this shift, sentiment towards black gold has risen sharply to the highest level we have seen in the 13 years of data which we have available – see exhibit below. Such readings put us firmly into extreme territory.
Exhibit 4: Crowd-Sourced Sentiment Vs. Price – Crude Oil
It is fair, therefore, to conclude that a great deal of positivity is already “in-the-price”, suggesting that the balance of risks for the crude oil price has become negatively skewed. (This negative skew arises because an extreme sentiment reading is a prerequisite for the concept we label “crowd fail”).
The absence of rising crowd sentiment towards future inflation, combined with the likelihood that the run-up in the crude oil price may be nearing completion – implying only a transitory inflation shock – suggests there is no sound basis for expecting monetary policy accommodation to be removed at an accelerated pace.
Unfortunately, there is another aspect to the crude oil price story that needs to be explored and considered – something that adds to the complexity.
Over the past several years, crude oil and equity prices have tended to track each other – positive correlation has been the norm rather than the exception. We can illustrate this in the exhibit below which plots the month-on-month percentage changes of the WTI crude price and the MSCI World Index since 2012. Over this period the correlation coefficient of daily returns (as opposed to monthly returns shown in the chart to avoid overlapping issues) stands at 0.32.
Exhibit 5: Crude Oil vs. MSCI World (m/m changes)
Source: www.amareos.com and www.msci.com
In situations where oil prices are being driven by demand-side shocks, a positive correlation makes sense as robust growth also drives equity prices higher. And, for much of this period, this was the case (see New York Fed data referred to in the blog detailed above). Our crowd-sourced sentiment indicators certainly suggest this has been the case in the past six months. There has been a rising tide of positivity towards economic growth over this timeframe (denoted by the outermost ring being mainly coloured green as opposed to red – see exhibit below).
Exhibit 6: Crowd-sourced Sentiment – Economic Growth
If, as our sentiment indicators suggest, the crude oil price is now looking toppy, does this positive correlation not also imply an economic growth/equity downdraft?
Not necessarily. Correlation does not imply causation and they can, and do, change (much to the annoyance of quantitative analysts). It turns out that one needs to pay close attention to the macroeconomic circumstances prevailing at the time.
After the experiences of the oil shocks in the mid-to-late 1970s, conventional economic wisdom was that rising crude oil prices constituted a negative growth shock. The underlying rationale is relatively straightforward.
Higher crude oil prices effectively transfer income from consuming to producing nations. Whereas the former adjust quickly to their new circumstances by curtailing non-oil related spending, the latter are slower to increase their spending. As a result, at the global level, a significant rise in crude oil prices occurring within a relatively short timeframe should be contractionary – an unfavourable economic scenario for asset prices.
This hypothesis was widely held to be correct. That is, until a couple of years ago. A problem arose when it did not tally with what occurred in 2014/15. The crude oil price slumped, a move mainly attributable to a positive supply shock. Saudi Arabia, as the world’s “swing producer”, added to global supplies in an attempt to make it uneconomic for US shale producers to challenge their dominant market position. This should have been stimulative to the global economy. It wasn’t.
Global equity markets largely managed to shrug off the first significant leg down in the crude oil price (from roughly USD 100 p/b to USD 60 p/b). However, during the second leg down, which began in mid-2015 and didn’t end until January 2016, equity prices slid around 20% – bear market territory.
Exhibit 7: Crude Oil Price vs. MSCI World Equity Index
Source: www.amareos.com and www.msci.com
Also during this period, crowd sentiment towards economic growth declined markedly as evidenced by the outermost ring being mostly red as opposed to green – see exhibit below.
Exhibit 8: Crowd-sourced Sentiment – Economic Growth
These moves, which were contrary to orthodox thinking, perplexed economists. In a 2016 blog several prominent IMF economists – led by Maurice Obstfeld the organization’s Chief Economist – sought to explain this counterintuitive result. The post was entitled “Oil Price and the Global Economy: It’s Complicated”.
Although the impact of falling prices on investment in the oil sector gets a mention, the IMF suggested a novel macroeconomic reason for the failure of the global economy to benefit from a mainly supply-led price drop. To wit,
“when an oil importer’s macroeconomic conditions warrant a very low central bank interest rate, a fall in oil prices could move the real interest rate in a way that runs counter to the positive income effect.”
Bearing this in mind, if a turndown in the oil price occurs and it is attributable to a positive supply shock (given the surprises that have come out of Saudi Arabia in the past several months who knows what could happen) then this effect should no longer be pertinent. After all, central banks are seeking to normalize monetary policy stances because macroeconomic conditions no longer “warrant a very low central bank interest rate”. Rather the effect should be more in keeping with what was expected in 2014 ie. positive for economic growth – a constructive scenario for asset prices.
Conversely, consider the situation where the fall in the crude oil price reflects a negative demand shock. While this would suggest weakening economic growth, concerns about asset price vulnerability because of accelerated central bank tightening should evaporate, especially as inflation pressures would be easing. Such a scenario may not be as market-friendly as an oil price decline caused by a positive supply shock, but this would only be because central bankers take time to reverse course – they suffer the same psychological flaws all humans do – meaning a monetary policy pause, or in extremis reversal, would not be immediately forthcoming (we are not converts to monetary policy impotence hypothesis). This suggests that any weakness in equity prices would only be transitory.
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