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Macro View: Plunging price of oil & China’s malaise prompt Bear market fears

SHARP stock market falls in the first three weeks of January 2016 are among the worst on record. Share prices in most centres fell below their August 2015 lows. The UK FTSE, the German DAX and Japan’s Nikkei all fell more than 20% below their 2015 highs, entering into “bear market” territory before recovering slightly.

While the initial panic subsided, a mood of pessimism persists. Even those willing to take risks – so far a minority – in the hope that recent falls provide a buying opportunity, are very uneasy over the health of the global economy. The key uncertainty is whether the early-2016 crash foreshadows a new recession, or whether we are seeing “only” an unpleasant market correction. Even if this benign view proves to be right, and this still seems most likely, there can be little doubt that recent events highlight genuine risks that could cause serious damage. The recent acute turmoil was overdone, but the markets will be very volatile in 2016. Share prices may test new lows before staging a sustained recovery.

Oil and toil
The key factors driving the early-2016 stock market plunge were heightened concerns over plunging oil prices and signs of slowdown in the Chinese economy. Superficially, these fears appear exaggerated. Although much cheaper oil and lower Chinese growth reinforce fears that the world economy may be stalling, it is hard to justify the frenzied reaction we have witnessed. One can legitimately argue that the markets focused exclusively on negative aspects, while totally disregarding many positive features.

But, although the panic was excessive, the markets’ reaction signalled genuine worries that cannot be shrugged off. At its recent low of $27 (£19)/barrel, Brent crude was more than 75% below its mid-2014 level of $115/barrel, an unprecedented drop that will unquestionably cause disruption and accentuate pressures on oil companies and on major oil exporting nations. But cheap oil also benefits oil importers, and boosts disposable incomes and living standards in most G-7 economies.

Macro official interest rates March 2016Click on the table to see the enlarged version

It is important to assess correctly powerful conflicting pressures. In 2015, GDP growth was inadequate and below-par in most countries and regions. This mediocre pattern is likely to continue in 2016. But the world economy would be even weaker without the benefits of much lower oil and commodity prices. Even so, the huge scale and abruptness of the oil price collapse reinforce dangers of debt defaults, either corporate or sovereign, which might unleash uncontrolled consequences. The fall in oil prices clearly reflects weaker demand in China and other economies, and this must heighten anxieties over global growth. But the abundance of oil supply in the last year is an even bigger factor pushing down prices; and, although this adds to volatility, the effects of increased oil output can be very positive. Oil has always been a very political product, and the current tensions in the Middle East (for example, Syria, ISIL and the Saudi-Iran clash) accentuate the geo-political risks.

In previous instances of downward oil price pressures, OPEC tended to restrain output, with the Saudis acting as swing producers. On this occasion, the Saudis continued to pump crude without any restrictions, even though they are also suffering when oil prices collapse. By pushing down oil prices, and keeping them low for a long period, the Saudis hope to damage mortally the shale oil industry in the US, which requires higher prices to be profitable. While shale oil is likely to survive, due to its flexibility and adaptability, the sector was hit very hard, and many wells were temporarily forced to stop operating. But the Saudi’s main strategic focus is to unleash a price war in order to limit the benefits that Iran may gain following the removal of international sanctions in the aftermath of the recent nuclear deal. The Saudis regard Iran as their main strategic adversary.

The tensions between these major regional players will increase in 2016, as Iran returns to the oil market as an exporter. This may worsen downward pressures on prices this year, as the battle for market share intensifies further. It is conceivable that oil prices could fall to $20/barrel, or even lower, in the next few months. But this is unlikely to last. In two to three years from now the overwhelming probability is that oil prices will be much higher than at present, even if global growth remains pedestrian.

An irreversible fact
China also highlights the markets’ tendency to exaggerate genuine threats. GDP growth is clearly slowing. But Chinese annual growth of 6.8% in Q4 2015, and 6.9% in calendar 2015, is still very respectable and much higher than in all the G7.

China’s official growth figures are likely to be inflated, due to political meddling, but China has still been a major success story in recent decades. Its emergence as a global economic super-power is an irreversible fact. Lower Chinese growth in the next few years is not a threat; rather, it is a necessary result of the economy’s planned rebalancing from manufacturing to services and from investment to consumer spending.

Macro GDP growth March 2016Click on the table to see the enlarged version

But China is also facing real challenges that heighten threats of a “hard landing”. Much of the massive investment made in recent years was wasteful, and the credit used to finance it will effectively have to be written off. This “debt time bomb” will have to be unwound carefully, without causing political turmoil. The Chinese authorities have lost some of their credibility in recent months. But the chances still are that they will be able to avoid a major crisis as they manage this difficult transition.

Did the Fed move too soon?
In the US, the economic figures appear to support the Federal Reserve’s decision in December to start edging up official interest rates. Our GDP growth forecasts remain at 2.5% for both 2015 and 2016, a mediocre but acceptable pace in the face of global headwinds. More importantly, the labour market data is unusually robust. The US created 292,000 new jobs in December 2015, much more than expected. The unemployment rate was stable at 5%, a seven-and-a-half-year low, and more people entered the labour force to seek work, signalling greater confidence in the job market.

But the carnage in the world’s stock markets was a shock, raising new questions whether the recent increase in rates came too early. The timetable of future rises must clearly be reassessed. Earlier expectations that the Fed funds rate would be raised three to four more times in 2016, by 25 basis points on each occasion, are no longer realistic in view of the turmoil. The Fed will now be much more cautious. We now expect two rate increases at most this year. Indeed, until the markets stabilise, all plans for further tightening are off the agenda.

In the UK, Bank of England Governor Mark Carney also made it clear that plans for early increases in Bank Rate will be postponed. A modest UK increase is still possible in Q4 2016, but most traders do not expect any UK tightening until early in 2017. In contrast to the US Fed and the UK MPC, which will postpone plans for higher rates but will keep policy on hold, the European Central Bank and the Bank of Japan will take active steps to ease policy further, with new expansionary measures likely to be announced in the next few months.

David Kern of Kern Consulting is Chief Economist at the British Chambers of Commerce. He was formerly NatWest Group Chief Economist.

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