OPEC Meeting On November 30th To Discuss Extending The Cuts
New Sentiment Indicator
It’s always interesting to see new metrics which attempt to give added insight. We have the consumer confidence index, the estimate on how much consumers plan to spend on Christmas gifts, and the consumer’s opinion on where the stock market will be in the next year. All three of those sentiment readings are at multi year highs. Unsurprisingly, the new indicator we’re reviewing tells the same story. As you can see from the chart below, the survey on households planning to take a vacation in the next 6 months is at the highest rate ever. There also appears to be more seasonality in the past few years of data. Considering the fact that this chart goes along with the narrative that the consumer is very excited, but spending at a more tepid rate, this chart is worth noting. If it painted a bearish picture, I would ignore it. It’s probably better to just review the stock returns of the vacation oriented names. Carnival stock is up 28% in the past year, confirming this reading.
The Oil Market & Energy Stocks
The chart below shows the price of Brent oil with labels on specific market moving events. As you can see, the price has been rallying since July. The cuts were extended by 9 months in May. Lately, there has been speculation about the cuts being extended further. At this point, it seems like a no-brainer that the cuts will be continued because if they ended, OPEC will end up right where it started; the cuts will have been useless. OPEC will be meeting on November 30th. As of now, there’s no plan on what decision will be made (as far as the length of the cuts). OPEC needs to convince Russia that the cuts are necessary.
Russia thinks it’s too early to announce a decision. The market appears to be pricing in the cuts being extended to the end of 2018, so if they aren’t extended, there will probably be drawdown in crude prices. Lukoil’s CEO said the deal should end if oil gets to $60. Currently WTI is at $56.68 and Brent is at $62.72. I think it’s weird to put a price target for the decision because if oil were to rally further, it would fall back down if the cuts were ended. It’s better to make a decision based on the supply and demand dynamics instead of near term price speculation. As of the current plan, the cuts will end in March. If a decision isn’t made in November, oil may selloff which would encourage OPEC to quickly come to a decision on extending the cuts in the following weeks.
The chart below shows the recent divergence between energy stocks and WTI. As you can see, energy stocks haven’t rallied along with oil prices which is frustrating investors in those names. The last time this divergence happened was in 2013 where energy stocks fell and oil was stagnant. That eventually led to the price collapse in 2014. I don’t expect a repeat collapse; I think energy stocks aren’t rallying because the price movements are short term noise. Once a decision is made on cuts, I expect WTI and energy stocks to converge one way or the other.
The chart below shows the speculators’ net longs in relation to the price of WTI. Unsurprisingly, there’s a high amount of speculation in WTI on the long side. The speculation was up 6.2% to a record high. You can see the high level of long speculation in the market before the correction in 2014. Once again, this doesn’t necessarily mean a crash is coming. Clearly, if the cuts aren’t extended, oil will fall, but other than that, it’s tough to get a reading on where it will go in the next few months. If oil falls back down to earth, it will cap the energy sector’s earnings growth which will already be facing tough comparisons in the 2nd half of 2018.
Draghi Speaks
Mario Draghi gave a speech on Thursday as the ECB is about to embark on the beginning of the end of its bond-buying program. Draghi stated that the main drivers of wage growth being below its potential are hysteresis, underemployment, globalization, and digitalization. Hysteresis is the theory that past rates of unemployment effect current and future unemployment rates. One example of this is the following scenario. A recession causes someone to lose their job. When the economy recovers, that person who lost their job might have lost the skills required to get a new job because the industry advanced while that person was sitting on the sidelines.
Draghi said the first two drivers should fade away and the ECB doesn’t see much evidence of globalization and digitalization. This is an interesting statement because he’s really painting himself into a corner. He’s saying there’s no way wage growth doesn’t accelerate in 2018. If he’s wrong, he will look foolish. It makes sense he’s optimistic since the ECB has announced the end of its bond buying before inflation met its goal.
A French company called Veolia, which has a BBB rating, became the first borrower with that rating to have a negative interest rate on its bonds. Draghi doesn’t want to talk about the effects something like that is having on the European economy. In fact, he doesn’t even think the low rates the ECB has set are affecting the banks’ profitability. He sees no flaws in his policies which is dangerous.
Conclusion
Tying the two topics we discussed together, if oil prices fall in the next few weeks, it will further depress inflation in Europe. Oil doesn’t affect core inflation, but it’s very important to the headline inflation calculation because it is so volatile. It’s possible that the E.U. sees deflation after the QE ends. The demographics of the E.U. imply very low interest rates, so it will be perennially tough for the ECB to reach its target of 2% inflation. On the other hand, if rates were to rise, the zombie companies lending at negative interest rates will fail en masse.
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