Here are our thoughts and notes on Oil along with Negative Interest Rates

Are we in a Bull or Bear Market?

• Observation: The recent rise in the stock markets is mainly due to the rising oil price and the central bank’s negative interest rate policy.
• Question: Are these moves sufficient to save the economy and change the market from a bear to a bull?
• Answer: No, we do not believe so.

The driving factor is oil along with the following observations:

1) Rise in Oil Price

2) Rise in Commodity Prices

3) Central Banks using Negative interest rates monetary policy

The impact of oil on the markets

• Oil has always been a supply and demand trade and the reasons why the price fell from US $110/barrel to today is because of the rise in production.  As well the magnitude of the fall causes the fear of deflation and is considered one of the main reasons for the entire market to fluctuate.
• Since January 2016, the oil price and S&P 500 are at a high level of correlation. The last time this happened was in the 1990s. (Fig. 1)

Fig. 1 – Oil & S&P500 highly correlated since Jan 2016

What level will oil rise to? The answer lies in the structure of this market:

• The reason it dropped in the first place is because the supply was dramatically increased over the last few years.
• Saudi Arabia no longer has a monopoly in this market.

OPEC

• Needed to make the oil price drop such that no one else makes money apart from them.
• Their cost is only $10-20/barrel.
• This is a direct attack on the US shale gas producers.

Countries still have a lot of oil reserves and are increasing supplies

• Western countries cancelled their sanctions on Iran leading to an increase in the supply of global oil.
• There is still a ton of supply in some countries this is more than 50-100 years to be harvested.
• They will continue to increase supplies because in 30-50 years the world’s dependence on oil will gradually reduce with other energy sources.
• Iran’s oil minister earlier said that it is a ‘joke’ for oil production group to freeze its production; Iran’s parliamentary elections have also increased uncertainty.

US

• Still heavily dependent on oil.
• Has been in full force to develop alternatives notably for cars: Tesla, Apple & Google.  These 3 companies are backed by the government with subsidies for both company and consumer of electric cars.
• Apple and Google to introduce cars by 2018.
• Tesla’s stock has gone from $10-$20 to over $200

Central Banks Using A Negative Interest Rate Monetary Policy

• The central bank policy has changed from supporting the market to undermining its stability.
• The market is looking for structural reforms and new fiscal policies by governments. But the chances are slim due to each having its own set of political problems.
• Only negative interest rates are used during this time. Which are also tied to the oil price.

Example: Japan Central Bank [April 27, 2016]

• Market expected Japan to further increase the negative interest rate policy, but the Japan Central Bank did not. The Nikkei dropped 1000 points [Nikkei from ~ 17000 to 16000] in 2 days as a result. The reason is because the oil price rose.  If the oil price rose and the central bank used the negative interest rate policy then once the oil price comes back down, they will have no policy measures to use to stimulate the market.
• Once oil drops again then they will potentially continue the negative interest policy.

The relationship cycle for worldwide developed markets

Fig. 2 – Current Economic Relationship in worldwide developed markets

KEY:

• It is observed that global GDP is not performing well and on the edge of deflation.
• This leads central banks to use a negative interest rate monetary policy, especially Japan and Europe.
• This further creates a difficult period for the banking business. With reduced lending for business activities, it is observed that worldwide businesses are generally weak.
• As business activities are weak, contributions to the country’s GDP are less.

We are still in a bear market

• Even if people say that the stock markets lead the economy by 6 months or so, every bull or bear market is formed by trial and error.
  • The market goes up, economic data is not good, then it comes back down.
  • The market goes up, economic data is not good, then it comes back down.
  • And finally market goes up, the data is good, then the bull market continues.
  • It generally takes 3-4 tries before a trend is developed.
• For a bear market, we have not seen it been completed in just one year.
• Therefore currently we are still in a bear market.

Example: Hang Seng Index

• July 2015 was the start of the China Stock Crisis and the start of the bear market
• In February 2016, some news said that it is the start of a bull market.
• There is a very low probability as it has only been 6-8 months for this bear market.
• The HSI has not risen since.

Conclusion

• Oil will not head back up to the previous highs in the short term even though there is good correlation with the stock market.
• Range is between $30 to $50.
• Strategically there may be a short term buy for oil around the $30 level.
• There are no real sectors in play this year apart from Gold which was already entered into in Jan and Feb with Model Portfolio Beta.

Fig. 3 – Category Quickrank Year-to-date performance highlighting precious metals (Source: hk.morningstar.com May 23, 2016)

Best,
Michael