Oil still in charge as investment growth drops

Oil prices have sunk in recent months

EVEN if oil prices pick up briskly from current levels, it will likely take time for meaningful energy-related investment growth to return to areas where operating costs, even after dramatic reductions, tend towards the higher end of the global scale.

If you believe the conspiracy theories, deterring such investment is exactly OPEC's aim. If that is the case, when the likes of Saudi Arabia will consider their work as complete is hard to accurately pinpoint – but we would be wise to expect more pain yet given the clear lack of agreement still in evidence between the major producers.

Nonetheless, the savage cuts in investment plans still being announced all over the world, particularly in the context of an industry that has to run hard in terms of investment just to offset depleting assets, would suggest that we are already setting ourselves up for the next surge in oil prices.

More broadly, we are still in a world where the travails of the commodity producers are more visible than the benefits accruing to the world's consumers of commodities. Business confidence around the world looks fragile on the latest reading, with February indicators for Europe pulling back again last week, albeit to levels still consistent with ongoing economic expansion.

This week, we will hear about the US business backdrop with both the ISM manufacturing and non-manufacturing February surveys due - previous divergence between the two has been narrowing alarmingly in the last couple of months.

For our part, we will be watching for any further signs of deterioration in service sector confidence as well as some confirmation from the more august manufacturing survey of a tentative bottoming in sentiment. Such a bottom would chime with views expressed by the various CEOs of the US industrial heavyweights attending our investment bank's annual industrial conference earlier in the month.

However, even if we do start to see a little more light at the end of the tunnel for US manufacturing, we should be prepared for oil prices to remain the pied piper for capital markets for a while yet. The correlation between global equity market returns and oil prices has been on the rise again this year. The seeds for this are likely found in the increasingly unhealthy relationship between oil, inflation expectations and bank stocks.

Correlations between oil prices and market implied inflation expectations have jumped back to perplexing levels this year. This doesn't make intuitive sense. Oil prices falling now could just as easily be seen as a medium-term reflationary not deflationary force because of the likely stimulative effect on consumption. However, there may be a somewhat circular logic at work here with banks caught in the middle.

The ongoing decline in expected inflation around the world continues to let the scant remaining air out of long end bond yields, providing a further existential threat to a banking model that relies on profiting from borrowing short and lending long.

As lower oil prices pass through the monthly inflation data over the course of this year, it should help ease misplaced fears of Japanese-style deflation and proxy currency wars among the developed economies. In the meantime, we are still left relying on oil prices to lead the various rats still plaguing parts of the world economy away.


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