Tue. Jun 18th, 2019

What The Oil Price Collapse Says About The Economy

In Tuesday’s technical update, I discussed the breakdown in the major markets both internationally as well as domestically. Of note, was the massive bear market in China which is currently down nearly 50 percent from its peak.

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What is important about China, besides being a major trading partner of the U.S., is that their economy has been a massive debt-driven experiment from building massive infrastructure projects that no one uses; to entire cities that no one lives in. However, the credit-driven impulse has maintained the illusion of economic growth over the last several years as China remained a major consumer of commodities. Yet despite the Government headlines of economic prosperity, the markets have been signaling a very different story.

In the U.S., the story is much the same. Near-term economic growth has been driven by artificial stimulus, government spending, and fiscal policy which provides an illusion of prosperity. For example, the chart below shows raw corporate profits (NIPA) both before, and after, tax.

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Importantly, note that corporate profits, pre-tax, are at the same level as in 2012. In other words, corporate profits have not grown over the last 6-years, yet it was the decline in the effective tax rate which pushed after-tax corporate profits to a record in the second quarter. Since consumption makes up roughly 70 percent of the economy, then corporate profits pre-tax profits should be growing if the economy was indeed growing substantially above 2 percent.

Corporate profitability is a lagging indicator of the economy as it is reported “after the fact.” As discussed previously, given that economic data in particular is subject to heavy backward revisions, the stock market tends to be a strong leading indicator of recessionary downturns.

Prior to 1980, the NBER did not officially date recession starting and ending points, but the market turned lower prior to previous recessions.

Besides the stock market, economically sensitive commodities also have a tendency to signal changes to the overall trend of the economy given their direct input into both the production and demand sides of the economic equation.Related: Abu Dhabi’s Remarkable Energy Diversification

Oil is a highly sensitive indicator relative to the expansion or contraction of the economy. Given that oil is consumed in virtually every aspect of our lives, from the food we eat to the products and services we buy, the demand side of the equation is a tell-tale sign of economic strength or weakness. This is shown in the chart below which shows oil prices relative to economic growth, inflation, and interest rates.

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All this data is noisy, so the next chart combines rates, inflation, and GDP into one composite indicator to provide a clearer comparison. One important note is that oil tends to trade along a pretty defined trend…until it doesn’t. Given that the oil industry is very manufacturing and production intensive, breaks of price trends tend to be liquidation events which have a negative impact on the manufacturing and CapEx spending inputs into the GDP calculation.

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As such, it is not surprising that sharp declines in oil prices have been coincident with downturns in economic activity, a drop in inflation, and a subsequent decline in interest rates. The drop in oil prices is also confirming the message being sent by the broader market as well.

Again, given the massive input that oil has on the overall economy, declines in oil prices have a much broader impact on the overall economy than just the energy sector. But the decline in oil isn’t the only issue weighing on our outlook for the markets.

A look at Baltic Dry Index, which is just a representation of the demand to ship dry goods, shows weakness has begun to spread globally. The Baltic Dry Index, which is a non-traded index, bounced from the lows in 2016 as global central banks infused massive amounts of liquidity into the system to offset “Brexit” risks. However, the index also suggests the “reflationary” surge has now ended.

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The same goes for copper which is highly correlated to overall economic strength due to its massive use throughout the production cycle both domestically and globally. The surge in liquidity in early-2016 was reflected with the “reflation” in a global economy which now appears to have ended.

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