Markets

Why Central Banks Wouldn't Let Cheap Oil Blow Up A Global Recovery

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The price of oil continues to climb. It was up 3% today, and is now up 78% from the lows on February 11th.

Remember, it was oil that sent shock waves through the global economy early in the year. Meanwhile everyone was focusing on China's economic slowdown, and ignoring the disease of cheap oil. In fact, most of the strategists and economist in the tall buildings in New York were telling us cheap oil was great for the economy. We saw it differently. We've talked a lot about oil in the past few months. In our note back on January 26th, we laid out all of the reasons oil could destroy the global economy, AND why the central banks would NOT let it happen.

We think it's important to always keep an eye on the forest rather than the trees, to keep perspective on the big theme, rather than the daily news. With that, today, we want to revisit that note from January. I think you'll find the script has played out beautifully. And with a robust oil recovery now underway, we have an economic environment that sets up, as we've said in recent weeks, for positive surprises and for a broad sentiment shift -- away from gloom and doom, and toward a more optimistic outlook. That shift means a lot for commodities, stocks, bond yields, the job market, the housing market...you name it.

Below is a revisit of our January 26th note, along with how things have played out ...

Since the global economic crisis erupted in 2007–2008, the world has slowly been in repair–mode, but we’ve had numerous events along the way that have shaken global investor confidence. And expect that to continue.

While interpreting the impact of events on the future path of economies and financial markets can be difficult, it often helps to step back, remove yourself from the noise, and look at the bigger picture. With our new short–daily notes, we want to give you our perspective in a world where media hype and fear tends to dominate investor confidence. We hope that it helps everyone to read through the bad messaging and make more informed decisions.

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Now, commodities and oil are front and center issues for markets at the moment. With that, we want to start our first note with some bigger picture perspective in that area.

As everyone likely knows, we've had the worst start for stocks on record for a New Year. Moreover, global markets in general remain in turbulence, with concerns about the shake–up in Chinese stocks and with uncertainty surrounding the Chinese government's stance on its currency. However, the bigger issue threatening the stock market and the global economy is the continued slide in the price of oil and broad commodities.

Oil prices have been manipulated to the tune of a 50% drop in 7 months.Oil has been pinned down by OPEC nations refusing to cut production, in an attempt to destroy the new U.S. shale industry (the competition). In a price environment where energy companies can't profitably produce oil, the only option is to turn off production, cut costs and wait for oil prices to come back to a level that is profitable to produce oil again. With that, as we've said, time is the worst enemy for the industry, including those that are rigging the game (i.e. OPEC nations). The longer prices remain low, the closer we come to wide–spread bankruptcies in the industry and fiscal deterioration of oil producing nations. OPEC is well aware of this.

But while many are warning of such an outcome, they are not seeing the bigger picture. If we step back and acknowledge where the global economy stands nine years into to the global economic crisis, we can clearly see that we are only in a position of relative stability and recovery because central banks took unprecedented actions along the way, coordinating globally, and committing trillions of dollars to avert a global economic apocalypse. They went “all–in,” backstopping failing institutions and governments, manufacturing a recovery in housing prices, and global stock markets in an effort to restore confidence, hiring and general economic activity. Make no mistake, higher housing prices and higher stock prices are two critical components of the Fed's gameplan over time, and other key central banks.

Still, the world remains fragile, standing on the wobbly bridge that central bank intervention has built with the hopes of ultimately finding some strong sustainable growth again.

A rigged oil market has the ingredients to undo all that the central banks have done for the past nine years to get us to this point. With that, we expect that, as intervention has stemmed the threat of everything that could have derailed recovery up to this point, intervention will be what stems the threat of the falling oil and commodity prices threat.

We expect to see either China or Japan step in as a big buyer of commodities. The Bank of Japan is already in the middle of the biggest QE program on record (relative to the size of its economy) and already pursues outright stock buying with their freshly printed yen. When China stepped in back in 2009, gobbling up dirt cheap commodities, they took the price of oilfrom $32 back to north of $100 again.

The greater question surrounding the stock market is a macro one. Will the free fall in oil, copper and broad commodities stop? We think the answer is yes. In the alternative scenario there will be no sector nor asset class to find refuge – i.e. it will have globally systemic ramifications. That's a scenario that the central banks, which have committed trillions of dollars over the past seven years to avert a global economic apocalypse, can’t afford to see happen, and won’t let happen. As we've noted, we think all of this is putting more pressure on China to act sooner rather than later. Stimulus from China has all of the ingredients to turn the tide on commodities – something the global economy needs.

For the meantime, the short sellers have been gaming these stocks, playing musical chairs. The music stops when OPEC cuts or a central bank (or central banks) intervenes.

We've always said keeping perspective on the big picture, in this environment, is everything. In this economic environment we’ve continued to see crises pop up, and the fear and panic ebb and flow. But along the way, we've always said to keep in mind that central banks are in control. And given the global breadth of the crisis, the structural weakness of the global economy, and the decision that global central banks made to go “all–in” to avert an apocalyptic outcome, they have no choice but to keep fighting together to bridge the world back to growth. THEN, and only then, the world can focus on the structural flaws that pose the threat of more crises to come.

Two central banks (the ECB and BOJ) have taken the QE baton from the Fed, and both have said they will do “whatever it takes.” That means, if need be, they print more money, they will support government debt markets, they will buy stocks, they will devalue currencies, they will dowhatever it takes to promote growth and to prevent a shock that would derail the global economy. Why? Because they know the alternative scenario/the negative scenario is catastrophic. [Update: The central banks did, indeed, respond. Japan stepped in on February 11, intervening in the currency markets. Oil bottomed that day. China followed with more action through a bank reserve requirement cut. The ECB rolled out bigger, bolder QE. And the Fed took two projected rate hikes off of the table. All of this put a floor under oil and sparked a sharp recovery, and global stocks followed.]

So we know that competitive posturing is influencing the slide in the price of oil. The great billionaire oil trader Boone Pickens has laid out the fundamental story for oil. He said the world is using 95 million barrels a day and is oversupplied by 1 million barrels. And he said it doesn’t take much to balance that market. “When that happens, crude will move up fast.” He still thinks we see $70–$75 this year.

The billionaires we follow have created their wealth by going into places where they see opportunity when no one else does (or others deem to be too risky). That's where the biggest returns are made. Right now, energy and broad commodities represent one of those areas. [Update: 36 of the top 50 gainers year to date in the stock market are commodity related stocks.]

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.