Historically, recessions have been accompanied by high oil prices. So is it possible to fall into recession with bottom-barrel oil prices?
With global equities down nearly 10% this year, the $15-trillion-dollar question is: What has caused such a swift and spectacular drop in sentiment?
Morgan Stanley’s Global Investment Committee (GIC) has been closely reviewing the macro news. While mixed, it has also been punctuated by a strong US jobs report and generally upbeat consumer confidence. Bonds, gold and the dollar have been volatile but ultimately range-bound. Chinese policy makers’ stock- and currency-market blunders certainly contributed, as did negative headlines, hawkish rhetoric from Federal Reserve officials and a backdrop of negative earnings revisions.
But the truly noteworthy development came from the oil market. In the space of three weeks, oil fell to $27.56 per barrel, its lowest level since 2003. While it’s ticked up again slightly, the fundamentals haven’t changed.
Rising tensions between Saudi Arabia and Iran, instead of adding a risk premium to prices, have produced an unexpected discount that has exacerbated the decline.
Next, the data on oil shows that despite low prices, production is not coming down fast enough, suggesting that the pain in oil would need to be even more severe to set a floor. This scenario has rattled markets, potentially spreading pain to financials, other industries linked to capital spending and, ultimately, to the job market and consumers.
This is a thesis first posited by Don Luskin of Trend Macrolytics in October which he recently summarized in a Wall Street Journal op-ed. While the GIC is not ready to embrace the energy-led recession idea, let’s explore it.
To start, this oil decline has now reached historic proportions, not only for its severity but for its duration. The spot price for West Texas Intermediate (WTI) has fallen 73% in 19 months—a cycle that is only rivaled by the one in 1998.
As bears are quick to point out, prices have plunged even as global demand has climbed 1.8 million barrels per day to 80.2 million barrels. But what if oil demand were to actually slip?
One theory is that this would create a self-feeding decline, tipping the world into recession because of the interconnectivity of low oil prices with the specific blend of emerging markets (EM) growth and debt financing that has characterized this cycle. Specifically, as Michael Goldstein of Empirical Partners has noted, half of EM capital spending is linked to commodity businesses, and these companies account for roughly 45% of all EM debt outstanding. In the 1997 EM debt crisis, EM growth was roughly one third of the world’s total; now, it’s nearly two thirds.
The counter case is that, in many instances, a recession is already priced in. EM equities, as well as global energy and capital spending-related stocks, are down more than 30% from their highs. Furthermore, we see no indications of impending recession, though some early warning lights, like credit spreads and flatter yield curves, have begun to signal caution. Similarly, looking back nearly 90 years, we find no examples of low oil prices causing a recession; in fact, nearly every recession in the period has been associated with high oil prices, with 1974-75, 1980-81 and 1990-91 being the best examples.
Rather than lead to recession, we believe that low energy prices are a stimulus for the 80% of global GDP contributors and that are in a multiyear rebalancing, in which wealth is shifting to consumers from producers.
Although the US consumption response to cheap oil has been weaker than expected, 2015 consumption growth accelerated to about 3% from the 2.2% average annual rate logged since the financial crisis. Low gasoline prices have supported a booming US auto market—not only are total units at multidecade highs, but the mix tilts toward higher-margin SUVs.
Current US labor force and income growth momentum show sustainability, despite the industrial recession and job losses in the oil fields, mining and materials, and among equipment makers. US nonfarm payrolls in December were up a whopping 292,000, with better labor-force participation and prior months’ revisions of an additional 50,000 jobs. The three-month moving average of job growth rose to 284,000, the best in nearly a year. While monthly wage growth didn’t show acceleration, year-over-year wages are growing at 2.5%, up from 1.7% at year-end 2014.
Also important, more than 700,000 of the jobs created in the past three months were full time, not just temporary seasonal jobs. What’s more, global leading economic indicators are heading higher, with momentum solid in Europe and stabilizing in Japan, China and the rest of the emerging markets. Finally, we doubt that central bankers will stand by idly if oil-driven deflation reaccelerates.
The bottom line: We don’t think that the global economy is heading for recession. That said, the inability of oil to find a bottom concerns us. We are clearly in uncharted territory, in which oversupply could conceivably cause a recession—especially if it undermines confidence.