Weekly Digest

A well-oiled machine

Richard Stutley, CFA

19 November 2018

Amidst all the Brexit-related headlines and discussions of trade wars, a steep decline in the oil price has gone by relatively unnoticed. Brent crude, the international benchmark, peaked at 86 dollars a barrel in October and since then has fallen back towards $65, in line with its level at the start of the year. This is good news we would argue, boosting disposable incomes for consumers which should support the current cycle, while the extent of the negative impulse from lower oil prices should be relatively limited.

Oil prices rose steadily through the first half of the year in response to falling supply from Venezuela and America’s pledge to reintroduce sanctions on Iranian exports after withdrawing from the Iran nuclear deal, and took another leg up from mid-August after reports of dwindling global stockpiles. Record output from the US and Russia, America’s decision to grant a temporary reprieve to importers of oil from Iran, and the impact of dollar strength on global demand for oil, has prompted a subsequent slide in prices starting in October.

Lower oil prices are clearly bad news for producers, prompting them to postpone spending on investment. Capital expenditure by energy companies in the United States is less than 10% of total capex however, hence the impact of this foregone investment is likely to be small in comparison to the boon for consumers.

With the US economy growing at 3.5% year-on-year in the third quarter, almost 2% faster than the Eurozone, the additional procyclical impulse from lower fuel prices raises fears of overheating. However this is one area in which dollar strength is having a positive impact, as highlighted in a research piece from Deutsche Bank . While in other areas the dollar has clearly acted as a headwind to markets, not least of all in emerging markets where equities have steadily declined post January, in this case it serves to tighten US monetary conditions. This means the Federal Reserve (Fed) can continue to be measured in raising interest rates.

Fed policy remains one of the key drivers behind asset prices in this current cycle. Should the Fed be forced to raise interest rates more quickly than currently forecast and more quickly than the economy, which is still heavily laden with debt, can tolerate, this would quickly stall growth. In this scenario we would expect most asset classes to struggle, with rising interest rates prompting bond prices to fall while the deteriorating growth outlook would simultaneously weigh on equities. Dollar strength reduces the risk of the US economy overheating and the need for an aggressive policy response from the Fed.

We expect the Fed to continue increasing interest rates gradually in response to strong growth and slowly rising inflation, which should support the current cycle and equities. This is how we are positioned currently, with a meaningful allocation to equities, which now offer a better entry point following last month’s falls. We are not wed to one scenario in building outcomes-based solutions for clients however, and hence alongside these positions we include a decent allocation to diversifying assets such as gold and liquid alternatives, with the aim of charting a steady course through what we expect will continue to be volatile times ahead.

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