Clime Weekly Market Themes
Australia: recession watch
We have in past editions quoted from the Evans and Partners “Recession Watch” commentary, which highlights the most significant factors which will determine whether or not Australia is likely to experience a recession. The most critical issue this year in Australia is whether the housing downturn deepens. The five key factors monitored to see whether recession is becoming more or less likely are:
- Finance constraints: will the banks increase lending now that the Royal Commission findings have been released?
- Homebuyer sentiment: will auction clearance rates pick up?
- Consumer and business confidence: consumer confidence is reasonably robust, but business confidence has fallen.
- The labour market: Labour market forward indicators like job ads and firms’ employment intentions remain encouraging.
- Construction orders. Dwelling approvals and orders for other types of construction are weak.
The summary chart shows an economy that is quite weak and deteriorating, but not currently close to being at recessionary levels. The improving commodity price outlook will also provide a significant offset.
Source: Evans & Partners
IMF cuts global growth forecasts
The International Monetary Fund cut the outlook for global growth to its lowest point since the GFC – which anticipate a larger slowdown in 2019 than previously expected. Why? A bleak landscape in most major advanced economies (especially in Europe, but also China and Japan), the possible collapse of trade talks between the US and China, and the risk of a departure of Britain from the EU without a deal. Growth in 2020 has also been revised down. The revisions are especially marked for Germany and Italy (which is already in recession). For China, there are small revisions, upward for this year and downward for next; the slowdown there is expected to continue.
Equity yields across the globe
For many months now, we have been emphasising yield as the most reliable component of total return in this low interest rate and low inflation environment. So it is interesting to look at the yield on equities across the globe. Perhaps surprisingly, Australia stacks up particularly well, with a projected dividend yield of 4.59%. This compares favourably with all other countries except Russia (5.6%) which is dominated by large resource stocks and where there is high governance and sovereign risk, and the UK (4.65%) where the risk of a no-deal Brexit is currently top of mind. On this basis, Australian equities look relatively attractive.
Global equity yields
Source: Eaton Vance
Oil price rising
Oil prices gained around 30% in the first quarter this year, with both WTI and Brent posting their best quarterly performances in some time. Opec’s supply cuts and declines from Venezuela and Iran following US sanctions have pushed the oil market into a deficit. Signs have started to appear that concerns over faltering demand growth last year were overblown. Demand has been resilient, and holding up more than pundits expected; oil prices have surprised to the upside.
WTI Crude over last 12 months
Assuming demand growth holds, supply is expected to further tighten with Venezuela and Iran under growing US pressure. OPEC and its Russia-led non-OPEC allies will review their production cut pact in late June. The situation in Libya is also adding “fuel to the fire”. It appears Libya is heading for a military showdown, which would generate additional bullish sentiment for oil markets. The possibility of further military conflict, which could spread to other oil producing neighbours, is keeping traders nervous. OPEC’s production cut strategy will be more effective if Libyan volumes are taken out of the market. As global oil demand is still growing, supply issues are likely to be increasingly bullish.
In March, Opec production fell by 534k barrels a day to stand just above 30m b/d. Opec has had to sacrifice market share to tighten the market and boost prices in the wake of the US shale oil production boom. Opec estimates that demand for its crude will have fallen by 2.6m b/d between 2017 and 2019. Last month, Saudi Arabia, cut production to 9.8m b/d from 10.1m b/d, while Iraq’s output declined by 126k b/d to 4.5m b/d. Venezuela’s output plummeted to just 732k, a decline of 289k b/d compared to February.
Oil price boom a “grey swan” event?
What of a scenario in which the oil price confounds expectations and breaks upwards, perhaps as high as $90 a barrel? While countries concerned about climate change want to move away from fossil fuels and China, whose rise fueled a commodity super-cycle, is starting to adjust to more normal growth levels, we are only a few years away from talk of “peak oil” and predictions of prices reaching $200 a barrel. While that looks well out of reach now, displacing oil as the mainstay of the global economy with electrified transport and heating will take time.
On the supply side, we see potential for tighter pricing conditions. OPEC has already cut production, US shale producers constantly need to drill new wells to maintain oil flow, and traditional exploration and production elsewhere has lagged since the financial crisis. Moreover, US producers are highly dependent on favorable credit conditions which could weaken in a rising rate environment. In any case, few countries now have spare capacity. OPEC may agree to reduce production further, despite pressure from the US to keep prices low, as Saudi Arabia needs oil to be above $85 a barrel to balance its budget. We could also see further disruption in the Middle East and in Venezuela.
On the demand side, there are multi-year demographic trends that point to increasing energy needs. In the short term, any positive global growth surprise could lead to upward pressure on oil prices, perhaps driven by China’s latest stimulus, higher fiscal spending in Europe, resolution of the US-China trade dispute and more favorable credit conditions now that the Fed has suspended its policy tightening. With the US now a net exporter, higher prices are likely to incentivize further capital expenditure and the additional revenue should offset any negative effects on domestic consumption.
If an oil price boom were to eventuate, one would want to be long commodities and commodity exporters (such as Australia and the AUD), and gain exposure through energy and materials sectors (Woodside, Oilsearch, BHP, RIO); be short energy-intensive sectors (e.g. Qantas) and net oil importers (like Japan). Protect against inflation by limiting exposure to already over-priced government bonds.
Chart of the week: NATO Defense Expenditure
Source: NATO, Geopolitical Futures