Oil anchors world financial markets, and Opec has just decided to raise its anchor. The consequences could be profound, and go far beyond the power game between the traditional oil producers in the Middle East and the new generation of shale producers in North America.
Oil, it is true, is less important than it was. Steady improvement in technology has rendered the developed economies less “oil-intense”, and less vulnerable to a repeat of the 1970s, when oil price spikes twice led to savage recessions.
But ever since the postwar version of the gold standard ended in 1971, with President Richard Nixon’s decision to end the dollar’s fixed price in gold, oil has been its closest replacement as a store of value in the world economy. In the 1970s, the savage oil price spikes in terms of dollars, engineered by a far more active Opec, merely restored oil’s value in terms of gold. US economic pump-priming had weakened the dollar.
A loose “oil standard”, with Opec adjusting supply to limit oil’s volatility, has cohered ever since.
Oil anchors capital markets most clearly through its tight inverse relationship with the dollar. When oil rises, so the dollar tends to depreciate against other currencies. Typically oil exporters receive payment in dollars and then sell them, meaning that higher oil prices lead to a lower dollar.
The dollar depreciated significantly in the years leading up to the 2008 financial crisis, and its nadir overlapped closely with a speculative bubble in oil. Now, it is strengthening significantly.
That correlation with the dollar leads to a second clear correlation, with emerging market equities. They tend to outperform when the dollar is weakening (as in the years leading up to 2008), and to underperform when the dollar grows stronger.
The last period to see falling oil prices (albeit at a much lower level), and a strengthening dollar was the late 1990s. That saw a US equity bull market melt up into a full-blown bubble, while emerging markets suffered a succession of crises. A stronger dollar made it harder to pay off their dollar-denominated debt.
From December 1994, when Mexico’s devaluation started a series of crises, until that cycle of crises ended in Argentina in 2001, the dollar gained 35 per cent on a trade-weighted basis – and developed world stocks outperformed emerging markets by more than 200 per cent, according to MSCI.
Assuming – as now seems reasonable – that oil does not rise significantly from here, and that any significant moves will be downwards, what are the chances of a 1990s repeat?
On the US end, the chance of a melt-up is directly aided by untethered oil. At the margin, cheaper oil provides a boost to the economy. The greatest boost goes to the consumer, precisely the sector that had been lagging: not for nothing was Walmart, the biggest US retailer, the strongest gainer on the US stock market on Friday.
As a significant component of price indices, cheaper oil automatically brings down inflation. This reduces the pressure on central banks to raise rates, and signals that monetary policy can stay lower for longer. As far as the bond market is concerned, forecast inflation for the next 10 years briefly dropped below 1.8 per cent on Friday, for the first time in three years – a level that has previously prompted the Federal Reserve to resort to QE bond purchases, and that certainly reduces the risk of imminent rate rises.
A stronger dollar is itself a tightening measure, making it less necessary for the Federal Reserve to act. A strong currency will tend to attract funds towards the US. And US stocks already look expensive. So if Opec will not act to keep a floor under the oil price, this certainly stokes the risk that the current rally in the US stock markets carries on until it boils over into a bubble.
Similar arguments apply to Japan, dependent on oil imports. As cheaper oil reduces inflation, which the Bank of Japan wants to force upwards, the chance of cheaper money in Japan only increases.
What of the rest of the world? Emerging markets are less vulnerable to currency crises now, as they have built reserves and (mostly) allowed their currencies to float.
That said, all countries that benefit significantly from exporting oil stand to lose. Above all, that means Russia, whose rouble has now dropped 53 per cent against the dollar since its 2008 peak. But India, dependent on imports for its oil, is surging – the rouble has dropped 36 per cent against the rupee in barely a year.
A full-blown repeat of the bubbles and crises of the late 1990s remains unlikely. The world should have learnt enough lessons to avert that. But the comparison still looks good – the risk is strong that as oil stays cheap, US stocks will boil over while emerging markets weaken.
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