Rising Oil Prices Pose a Challenge to Global Monetary Easing
Financials markets have managed to climb the wall of worry in recent months on the back of better U.S. economic data and the reduction in European risk premium. Risk assets have also enjoyed a wave of monetary easing by global Central Banks. Liquidity has certainly eased credit concerns in Europe to a large degree but rising oil prices and inflation expectations may constrain further monetary easing, particularly in inflation sensitive emerging markets. Therefore, in light of fiscal austerity in Europe and rising geopolitical risk in the Middle-East, we expect the market to focus its attention to the sustainability of global economic growth.
The People’s Bank of China has recently stated that they plan to increase money supply growth to 14%, which is likely to be implemented by a series of cuts in the Required Reserve Ratio for its banking system. However, rising oil and other commodity prices may act as a constraint to meaningful monetary easing. In addition, investors seem to be under-appreciating the structural change that China is trying to implement on its economy i.e. a shift from infrastructure growth to a more consumer spending driven economy.
China’s current 5 year plan (2011-2015) targets a growth rate of 7% i.e. lower than the recent 9-10% growth rate. Thus, one cannot ignore the resulting reduction in the global economic multiplier effect – especially as Europe has more leverage to global economic growth than the U.S. economy. Moreover, Europe’s energy bill is likely to make the ECB’s easing policy more complicated. As we can see above, Brent crude oil in Euro terms is making new highs. Therefore, at a time where the Euro needs to depreciate in order to improve the Eurozone’s competitiveness, rising oil prices are making European growth prospects even more challenging.
On the U.S. front, as we can see from the below charts, long-term inflation expectations are on the rise and investors seem willing to endure even negative long-term yields on Treasury Inflation Protected Securities (TIPS). On the consumer front, the risk of rising gasoline prices puts retail spending at risk, especially for more vulnerable income groups. Headline and core U.S. inflation may be currently tolerated but the prospect of increasing energy and food prices may restrict the Fed’s leeway for future quantitative easing, which could potentially cushion the economy against the currently projected 2013 fiscal drag (~3%).
On the monetary front, we note that with bloated excess banking reserves and elevated money growth in the U.S. it seems that the Fed’s easing policy is hitting against a wall i.e. any further quantitative easing risks future inflation expectations to be unchecked. On the European front money supply growth faces different challenges, as the ECB’s loan facilities are expanding the money gets parked at the ECB instead of being turned into credit that flows in the real economy. The primary problem is bank deleveraging as we discussed in past articles.
With rising oil prices and unstable political regimes, policymakers are best advised to look at other energy solutions. As we discussed in our 2011 Energy reviews (please see appendix), the U.S. (and other global economies) have to lower their energy bill via the exploitation of unconventional natural gas and shale oil, whereby hydraulic fracturing is impacting the supply/demand picture meaningfully. In the short-term, the U.S. natural gas sector is experiencing an oversupply of the fuel which has resulted in depressed pricing. Yet, as we can see below, producers are cutting back their drilling efforts. Over time, we expect natural gas to be the fuel of choice for power generators due to environmental concerns. The trend in the use of electric cars also bodes well for increased demand for power. In addition, we expect the transportation sector to make further use of compressed natural gas (CNG) as a fuel e.g. for trucks. Lastly, the U.S. is also on its way to build Liquefied Natural Gas (LNG) export terminals that will enable natural gas to be sold to higher priced global energy markets e.g. Japan and Europe.
In conclusion, we note that the ECRI’s leading economic indicator has been rebounding as of late along with the equity market which is considered itself a leading or discounting mechanism. However, as we explained above, there are risks to economic growth and one should expect sporadic episodes of volatility in risk assets. We thus continue to assess the risk-reward profile in the market and we maintain a balanced portfolio of income generating assets and undervalued securities.
Appendix:
http://www.edgewealth.com/updates/archive/2011/a-view-on-us-power-generation-prospects/
http://www.edgewealth.com/updates/archive/2011/a-view-on-us-oil-industry-dynamics/
http://www.edgewealth.com/updates/archive/2011/n-american-energy-infrastructure-view/
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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