The European situation is still flirting with recession, if we look at the latest PMI data. I think the drop in oil prices will give the Europeans an unmitigated boost but the longer-term situation is still dire given the policy framework in place. In the US, on the other hand, the economy is doing well and will continue to do well despite the problems in the shale community. These problems are becoming more severe, however, and that means we cannot rule out a crisis down the line. But right now, everyone seems to be talking about crisis in Russia and making parallels to 1998. I think these fears are unwarranted and will explain below.
I have taken to reading audiobooks recently and really like the experience. Just the night before last I finished a German-language audiobook called “Vermächtnis” about former German Chancellor Helmut Kohl. Basically, Kohl picked out journalist Heribert Schwan to talk to about his life in order to make an autobiography. The interviews produced over 600 hours of tape. But Kohl’s controlling younger second wife has tried to prevent these tapes from seeing the light of day because they are so revealing. Schwan has therefore written this book to memorialize his sessions with Kohl and their amazing insight into the thinking of the man that led Germany for 16 years and reunified the country.
The unfiltered Kohl is a bit shocking really. But I don’t want to dwell on that aspect. What did strike me, however, was how much the First and Second World Wars affected Kohl’s world view and drove German policy while he was Chancellor. The reality is that Kohl is from a generation that grew up under Hitler and suffered the triple humiliation of two war defeats and acknowledgment that unspeakable crimes against humanity were committed in their names. Kohl lost an uncle in Word War 1 and a brother in World War 2. As Chancellor, he was the last of his generation, and the last German Chancellor of the great French-German Versöhnung. Gerhard Schröder and Angela Merkel represent a new, more muscular and less emotionally encumbered Germany.
I think this matters. Frankly, I think it matters a lot. The audiobook I listened to talked of the friendship between and mutual admiration of Center-right German politician Helmut Kohl and socialist French President Francois Mitterand driving European integration forward. And this was just as true as Adenaur-De Gaulle and Schmidt-Gistaing before. No one talks of a Schröder-Chirac or Merkel-Hollande special relationship because it doesn’t exist. And again, this matters.
The economic framework controlling the eurozone is inherently deflationary. The goal is to minimize state debt and deficits and simultaneously attain sustainable long-term economic growth. These goals are not necessarily compatible in an environment in which the Germans are taking a much more self-interested view of their economic and political union with the rest of Europe. If Texas goes into a tailspin because of a bust in the oil patch, the automatic stabilizers will kick in and the tough times will pass without an existential crisis. We saw this already in the 1980s. But, in Europe, those automatic stabilizers don’t exist, basically because of a fear of ‘free riders’ that is incompatible with a currency union.
This is the lens through which I view the economic picture of Europe today. I see Europe has broken politically. And any short-term economic gains will be lost as the political hurdles come into view. Supposedly, the Germans now support a dual mandate for the ECB that includes growth along with inflation. So what? We have known for some time that price stability is not the sole mandate of the ECB. What does that mean from a practical perspective?
If you look at the drop in oil prices, it means less monetary easing. Here’s what I am hearing out of Germany. Oil prices are down and that’s going to give consumers more discretionary income. In fact, the boost will be enough for us to cut back on the extreme measures people like Mario Draghi and Peter Praet are trying to take to deal with deflation. The drop in oil is thus a dividend that we can use to maintain a slightly tighter monetary policy.
Meanwhile, the numbers out of Europe still suggest stall speed. Yesterday, the euro fell to a 27-month low against the dollar after Markit’s composite purchasing managers’ index for November came in at 16-month low of 51.1, down from the previous month’s October’s 52.1. Now, I agree that the numbers are likely to get better from here as the oil dividend takes hold. Nonetheless, Europe really is still just a few steps away from recession. The Juncker plan won’t get it done. I don’t think QE or the ECB’s ABS program will get it done either. Higher deficits will get it done though. Just look at the UK with its deficit at 5% of GDP. That’s huge. And it is the reason that the UK has the best 12-month economic expansion in the advanced economies. But, deficit expansion is the opposite of what Europe is trying to achieve. After all, even the Germans are going for a balanced budget now.
So as much as I believe Q4 and Q1 2015 will surprise to the upside, the policy framework in place is still restrictive. And in the end crisis will come again, as surely as day turns to night.
Speaking of crisis, what about the oil patch? Bloomberg is talking about sub-$50 oil per barrel from the well head in North Dakota.
Oil market analysts are debating if oil will fall to $50. In North Dakota, prices are already there.
Crude sold at the wellhead in the Bakken shale region in North Dakota fell to $49.69 a barrel on Nov. 28, according to the marketing arm of Plains All American (PAA) Pipeline LP. That’s down 47 percent from this year’s peak in June, and 29 percent less than the $70.15 paid for Brent, the global benchmark.
The cheaper price for North Dakota crude underscores how geographic and logistical hurdles can amplify the stress that plunging futures prices have put on drillers in new shale plays that have helped push U.S. oil production to the highest level in 31 years. Other booming areas such as the Niobrara in Colorado and the Permian in Texas have also seen large discounts to Brent and U.S. benchmark West Texas Intermediate.
ITG Investment Research says we need $63-65 a barrel to break even at Bakken. How long can producers there hold out at $50? Will the price fall lower? Are they hedged and for how long? My sense is that the hedges in place are going to take us through somewhere into 2015 at the most and then we will see real pain here and that’s when the defaults will begin. An oil bust and defaults doesn’t mean the US economy falls out of bed. But it will have an impact and if the bust is severe enough it will provoke a crisis.
Now, the crisis that everyone seems to be latching onto is Russia. The ruble is in freefall and capital flight is rampant as a result. Rumours about impending capital controls are rife. I think these fears are overblown. Yes, the ruble is falling and that will mean inflation. For example, annual inflation in Russia through November came in today at 9.1%, ahead of estimates for 8.9%. But so what? The Russians themselves have said that the economy will contract by 0.8% next year. They had previously estimated the economy would grow by 1.2% but sanctions and economic turmoil is causing a deep revision. But of course 0.8% is not 5% or 10% as we saw in several European countries in 2008 and 2009. Where’s the crisis?
I don’t mean to be flippant here but the whole meme strikes me as nonsensical. Where we should be concerned about Russia is in terms of corporate foreign liabilities just as I believe this is the potential genesis for crisis throughout the emerging markets. As the Ruble drops, those foreign currency liabilities, if unmatched by foreign currency revenues, become onerous. And given the fact that Russian corporates are effectively cut off from dollar and euro funding markets, you have a problem. But that’s a problem, not a crisis. It’s not 1998. It’s not sovereign default and LTCM.
So, when it comes to the crisis watch, while I think we are going to eventually see more in the eurozone, we are not there yet. If anything, the near-term in Europe looks better than it did two or three months ago, PMI data notwithstanding. The same is true in the US. 200,000 jobs per month, low initial and continuing jobless claims, and robust ISM data means we should expect retail sales to be strong and GDP as well. The real problem is oil. The Russian crisis talk is a red herring. The real problems are with the overleveraged shale producers in North America and in the private portfolio preference shifts from a lack of petrodollar recycling that reduces market liquidity.
To me this speaks ever more to a need for a slightly more defensive posture, consumer staples over cyclicals, stable big tech like Apple or IBM over growth big tech like Amazon, and more down-market Walmart and Target over high-end Coach and Tiffany’s. We are closer to the end of this business cycle than we are to the beginning. And despite the boost to consumers, the drop in oil price will accelerate via this change rather than retarding it.