Despite the hit to shale oil and the stronger US dollar, employment and real incomes are rising, while the latest GDP figures show consumer spending +3.2% year-on-year, residential investment + 9.2% year-on-year and total fixed investment +3.6% year-on-year. The likely impact on the economy of defaults in shale debt comes down to whether you believe that cheaper oil is a net positive or negative for the US economy as a whole.
The contrary view to our base case assumption of a positive effect on global growth is that the main reason for the fall in the oil price is weak global demand, at a time when inflation is already low. With inflation and interest rates already so low, there is little to be gained by pushing inflation even lower, indeed it may encourage the onset of a deflationary mindset among households and firms. To date, there has been very little evidence to support this deflationary mindset thesis that consumers will postpone spending, as they wait for the prices of goods and services to fall further.
Looking ahead, the main drivers of the oil price are likely to be whether OPEC decides to cut production, the supply elasticity of higher-cost production such as US shale, and geopolitics. If there is a marked decline in investment in high-cost supply, this will have a longer term impact on the balance of supply and demand and tend to push prices higher. On the other hand, technological advances could lower the costs of oil production and reduce break-even costs. The risk of a sustained jump in the oil price is contained by supply elasticity of shale: the average life of a well is short, with producers able to pre-sell the entire expected output of a well, before production commences.
Assuming the focus shifts from oil losers to winners, how should investors be positioned?
Equity markets in the major oil importing regions, such as Europe and Japan should continue to do well. Consumers in these regions should benefit from the “tax cut” effect, as should companies which are intensive users of oil. US consumers should also benefit, however with the Fed set to raise interest rates, this should curtail the performance of consumer related sectors within the equity market. Companies dependent on the oil sector, either as producers or as manufacturers of oil equipment, will continue to come under pressure until there are clearer signs that the oil price has stabilised.
