Article / 02 December 2014 at 14:24 GMT

Investment Outlook: Oil and money, milk and honey

CIO / Saxo Private Bank
  • Crude oil down 36%, Opec decision may see further declines
  • ECB-led sovereign QE may commence early next year
  • Global growth forecast could turn around in 2015

By Teis Knuthsen

Global equities rose by 2.7% in November and several markets reached new historical highs. At the same time, bond markets continued to climb, and in several European markets 10-year government bond yields fell to all-time-lows. November thus contributed to the overall picture of 2014 as an unusually benign investment year, with considerable gains on most asset classes.
Oil and money

While many asset prices have risen in value, this is definitely not the case for oil. Since their peak in June, oil prices have fallen by 36%, reaching their lowest levels since 2009. It may seem natural that oil prices have fallen as global economic growth has slowed. But to understand the depth of the recent decline, one must look to the US. 

The US now produces almost three times as much oil as it imports from the Middle East. Combined with a strong rise in the production of shale gas, the US has become the swing factor in global energy production. The Opec countries could have addressed the issue by announcing production cutbacks at the November 27 meeting, but chose otherwise. Further price falls may ensue.


High production, slowing global demand and Opec's recent decision 
could result in even lower oil prices in 2015. Photo: Tomas Sereda \ iStock

Energy is first and foremost a production input, so when oil prices fall it can be seen as a global tax cut. Within a country such as the US, wealth is distributed from producers to consumers, and inter-country wealth is transferred to the US, Europe and Asia from (for example) Iran, Russia and Venezuela. 

The impact on Russia is severe when combined with the economic sanctions that are already in place, and a recession seems unavoidable. The ruble has fallen to new lows.

If falling oil prices lend support to consumers around the world, then falling energy prices may become a challenge to central banks in Europe and Japan. As oil prices have fallen, so will headline inflation in the coming months.

As for the global economy as a whole, we have enjoyed low and stable inflation (just below 2%) in recent years. I do not share the widespread fear of deflation, and see a very low probability for falling wages and housing prices that could cause a more severe downturn. However, for the European Central Bank, cutting inflation when Consumer Prices Index figures are as low as 0.3% year-over-year represents a tactical challenge.

Sovereign QE in Europe

During the past few months, the ECB has acknowledged that it must do more to ease monetary conditions. Rates are already at the zero-bound and the money base — which is the part of money growth that the central bank can control directly — has been falling. Further, credit growth is still negative.


ECB headquarters in Frankfurt: the central bank's stimulus operations are operating 
within significant constraints. Photo: J. Chambers \ iStock

That the money base (also referred to as the ECB balance sheet) has been falling is partly linked to banks paying back longer-term "repos" (long-term refinancing operations) from 2012, and thus is at least partly a technical issue. 

Nonetheless, the ECB has on several occasions over the previous weeks specified a target for money base growth over the coming years, consistent with a rise of approximately 1000 billion euros until the end of 2016.

The ECB has already initiated a number of new policy measures, including a new round of longer-term repos (TLTRO), and purchases of asset-backed securities and covered bonds. There is talk of quantitative easing targeted at corporate bonds as well. 

However, the markets are too small to get the ECB to its balance sheet target, and the elephant in the room remains sovereign QE, or direct purchases of government bonds. This now seems to come into play in the beginning of 2015.

A reasonable question here is whether it makes any sense to buy, say, German government bonds with 10-year yields at just 0.7%. For the answer to be positive, you need a strong faith in the indirect effects of such programs.

However, there is no escaping that QE, in whatever form, can have a significant impact on financial markets in the form of lower inter-country yield spreads, lower corporate spreads, higher equity prices, and a weaker currency. 

The recent experience from the US is that successful QE may lead to a moderate rise in government bond yields, but until the program gets underway in Europe the path of least resistance is for a further decline.

All onboard in Japan

November also saw a massive increase in already extremely aggressive QE policies in Japan. Bank of Japan governor Haruhiko Kuroda threw caution to the wind when he promised to expand the money base by as much as 16% of GDP per year in the coming years. 

This is a policy experiment beyond the scope of anything we have ever seen before. Personally, I doubt its efficiency and worry for its stability, as I fundamentally don’t believe that a credible central bank can create inflation. 


Japan's planned central bank moves are incredibly bold. Photo: iStock

Many economists will disagree with me, but if anything, the US experience shows that QE works alongside other policy programs (fiscal, bank balance sheet repair, structural reforms, etc.), and not in isolation which is what we are really getting from both Europe and Japan at the moment.

For both the ECB and BOJ, currency depreciation will be part of the plan. For the US, a rise in the value of the dollar and lower inflation (as a result of falling energy prices) will make life easier for the Federal Reserve as it prepares to raise interest rates next year. This next turn in US monetary policy now appears to be getting underway very cautiously.

China has also eased monetary policy recently with the first rate cut in more than two years. Taken together, monetary policy across the world remains highly accommodative, is designed to support economic growth and is specifically aiming to do so through financial markets.

Milk and honey

Lower oil prices, weaker currencies and a more expansive economic policy are lifting the economic outlook for both Europe and Asia in 2015. No one needs to cheer for the US economy, as a broad-based and self-sustaining upswing is already well underway. 

In China, growth is decelerating, but at around 7%, expansion in the world’s second-largest economy remains brisk. If a hard landing can be avoided, much will have been gained for the global economy.

In general, global growth has decelerated this year, thanks to a downswing in the short-term inventory cycle. Most likely, this cycle is turning as you read this, lifting global growth to higher activity levels in 2015.

Investment conclusions

In October, I recommended a shift down in risk to neutral, through a reduction in the allocations to equities and to high-yield bonds. I recommend keeping risk profiles at neutral until it becomes clearer whether the short-term cycle is indeed turning up again, or whether we are preparing for a deeper downturn. 

Driven by reasonable valuation, substantial earnings and a very supportive setup for monetary policy, equities remain the asset class of choice.

Businesss cycle overview and asset allocation key

Source: Saxo Bank

-- Edited by Michael McKenna

Teis Knuthsen is CIO of Saxo Private Bank. Follow Teis or comment below to engage with Saxo Bank's social trading platform.


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