Oil, Inflation and Fed Policy

Paul M. Kitney, [email protected]+852 2733 1000 (Direct)+852 2733 1031 (Main)+852 6975 8444 (Mobile)

Asia Pacific Investment StrategyAugust 30, 2016

ANIMAL SPIRITS PART 1: Macro Backdrop – Base Jumping the Fed with Oil and Inflation ExpectationsAsia Pacific Investment Strategy• In the following series of introductory notes, Animal Spirits will outline the investment process and analytical framework we employ to provide context for the regular pieces to follow.• Animal Spirits is an equity-focused Asia Pacific Investment Strategy report. It harnesses macro, fundamental, and quantitative analysis and selectively incorporates and interprets elements of academic and central bank research where it is helpful to the investment process. Animal Spirits is structured in a long run framework but the investment horizon is tactical, usually in the 3-6 month range.• We begin with ANIMAL SPIRITS Part 1: Macro Backdrop – Base Jumping the Fed with Oil and Inflation Expectations

The dominant paradigm in 2016 has been deflation, fueled by a series of shocks. The energy market has transmitted shocks through to the real economy via the credit market, which is part of the Fed’s policy reaction function. Central to Fed decision making is inflation expectations, which are influenced by YOY changes in oil prices. The deflation paradigm has been characterized by a generically weak commodities sector, chronic underperformance of emerging market (EM) equities and impressive outperformance of the US equity market. A paradigm shift - or at least a pause in the current deflation regime -is likely underway. This should consist of two consecutive phases:1. EM Goldilocks - APAC EM equities and associated currencies are likely outperform into 2016 year end, driven by market clearing in the commodities space. The Fed will run "hot" for a while.2. Fed responds to a possible “inflation surprise” in Q1 2017 with at least one rate hike, reacting to an oil price "base effect" and possibly a stabilization in the liquid energy demand-supply balance, which would exaggerate this effect.

• Next in this series is: ANIMAL SPIRITS Part 2: Earnings and Valuation Snapshotis owned by Paul M. Kitney, PhD, licensed to Ballingal Investment Advisors and is pending registration.

ANIMAL SPIRITS • BALLINGAL INVESTMENT ADVISORS1

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BALLINGAL INVESTMENT ADVISORS

The dominant paradigm in 2016 has been deflation, fueled by a series of shocks. The first shock was the Fed lifting the federal funds rate off the zero lower bound (ZLB) in December. Then, the spike in global risk premiums, after the sharp RMB devaluation in August 2015, was repeated in February 2016. Distress in the US high yield energy sector, led to a risk shock transmission from high yield to investment grade energy credit and to the corporate credit market as a whole, as shown in Figure 1.Figure 1 – US Energy Sector Credit Spreads

Source: Ballingal Research, Barclays (Barcorp US HY-10Y Treasury Spread), Bloomberg (US HY and IG Energy Option Adjusted Spreads), Data as of 12/8/2016

Ground zero for deflation is Japan, which has been battling it for over two decades. The first half of 2016 has seen little change, with the BOJ having repeatedly failed to meet its 2 percent inflation target. It followed the EU/Swiss example and implemented a negative interest rate policy (NIRP). The more recent shock has been Brexit.The monetary policy divergence between the Fed’s attempts at normalization and the rest of the world pursuing somewhere between loose orthodox policy to more extreme versions of quantitative easing and NIRP, has induced a strong US dollar. This has been accompanied by a generically weak commodities sector, chronic underperformance of emerging market (EM) equities and an impressive outperformance of the US equity market, together with an equally impressive expansion in valuation multiples. (See a global valuation comparison in the upcoming: ANIMAL SPIRITS Part 2: Earnings and Valuation Snapshot)Animal Spirits has observed over various market and economic regimes that scarcity demands a premium, associated with the prevailing paradigm. This plausibly explains the macro outperformance of the US equity market, as growth and quality (lower volatility) of earnings have been scarce in the first half of 2016 and as such the US has had a better offering than global peers. Similarly, in this deflation paradigm, yield is scarce, which is why valuations have risen on stocks with superior yield factor characteristics, a market microstructure example of the scarcity principle.

ANIMAL SPIRITS • BALLINGAL INVESTMENT ADVISORS

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A paradigm shift or at least a pause in the current deflation regime, is possibly underway. This is likely to consist of two consecutive phases:EM Goldilocks - Asia Pacific (APAC) EM equities and several of the constituent currencies may outperform into 2016 year end, driven by market clearing in the commodities space, resulting in a reprieve in commodity sector earnings. The Fed will probably let the US economy run “hot” (allow inflationary forces to resurface, at least temporarily) during this time, holding back on further policy normalization, providing the fuel for a strong “catch up“ rally in EM. The Fed is aware of the negative effect deflation has on consumption and investment and may wish to let a little inflation boost US domestic demand, at least short term without a blunt policy response. Shifting inflation up from the ZLB mentality must be at the forefront of central bank decision making. Whether this is achievable or not is another matter but Animal Spirits sees at least a hiatus in deflation over the next quarter or two. Fed responds to a possible “inflation surprise” arising from the oil market in Q1 2017, with no fewer than one rate hike. At the very least, the oil price base effect may be a boost to inflation expectations in Q1 2017 and there is growing evidence the oil market is getting closer to clearing. If the global oil market excess supply balance clears then the positive impact on inflation expectations via the WTI YOY comparison, will be more exaggerated. In either case, the data dependent Fed will not ignore forever the primary variable in its policy reaction function, inflation and its evolution (explained below). The Fed will be tempted to run “hot” for a while but part of challenge of getting the economy off the ZLB mentality is credibly raising rates in response to inflation and its expectations. This may signal a resumption of “policy divergence” and a US dollar rally in Q1 2017. This theme is explored next.“Near” full employment has not been enough to induce the Fed’s 2 percent inflation target and is explained largely by oil price deflation. Oil is not a component of core inflation but it feeds into inflation indirectly via inflation expectations. The Fed’s policy reaction function consists of looking at the gaps between current and long run unemployment (NAIRU), the inflation rate and the target rate and other factors such as credit spreads1. Figure 3 shows the co-movement of the YOY change in oil prices (red) and the Michigan 1 year inflation forecasts (blue). Inflation expectations have been edging down with the WTI price falling from over $100/barrel in mid-2014 to $26/barrel in Q1 2016. While the current 4.9 percent unemployment is nearing the NAIRU and 1.6 percent inflation is close to the inflation target, Animal Spirits contends that the Fed would have raised the fed funds rate by another 25-50 basis points had the oil market not reduced inflation expectations and increased credit spreads in H1 2016.

1 Kitney, Paul M., Does the Central Bank Respond to Credit Market Factors? A Bayesian DSGE Approach, CAMA Working Papers 2015-21, Australian National University


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Figure 2 - US Baker Hughes Oil Rig Count and WTI Price

Source: Baker Hughes, Bloomberg, Ballingal Research

Figure 3 - US Inflation Expectations, Spot and Projected WTI Prices

Source: Federal Reserve Bank of St. Louis, University of Michigan, EIA, Historic Data as of 31/7/2016, Forwardlooking YOY based on EIA estimates and fixed historic end-July data.

In Figure 2, the Baker-Hughes US oil rig count is plotted against WTI. The recent 60 percent rig reduction is similar to the GFC and the Dot Com Crisis. In these cases, the global oil market cleared. According to the EIA (August), the market for world liquid fuels will balance between Q2 and Q3 2017, with a 2017 mean WTI forecast of $52. The IEA (August) claims the oil market has already cleared. In Figure 3, Animal Spirits projects a YOY rise in WTI based on both constant-July 2016 prices (green) and EIA estimates (purple). Both cases point to a rise in WTI YOY between November and May, implying a rise in inflation expectations. This and falling credit spreads improve the case for a Fed rate hike in Q1 2017.


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Oil, Inflation and Fed Policy

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