Could Rising Oil Prices Help The Economy?

TV Sentiment For The Next 12 Months

The chart below shows the financial TV sentiment for the economy, stocks, volatility, emerging markets, inflation, treasury yields, and commodities from 2013 to 2018. It’s amazing to see how this sentiment indicator had almost 100% optimism for inflation in 2017, but inflation didn’t perk up. As a result of that disappointment, inflation sentiment has worsened even though the environment for higher inflation is even more ripe. Generally, this sentiment is backward looking. Two of the changes for this year which aren’t backward looking are that equity optimism has fallen and volatility optimism has increased. This is likely because some analysts think the market is due for a decline. As we’ve reviewed, just because stocks were up a lot in 2017, doesn’t mean 2018 will be a bad year.

That being said, I do agree with the optimism for volatility along with the optimism for commodities, the economy, treasury yields, and emerging markets. The fact that equity optimism isn’t high either means the stock market isn’t in a bubble or that financial journalism no longer acts as a reverse indicator because journalists have gotten smarter. It’s easy to get information because of the internet. Therefore, I’m guessing more journalists are aware of how expensive stocks are now compared to the 1960s. There have been many reports about the Canadian housing bubble, showing how the journalists aren’t far behind. The concept of acting against the headlines is an anecdotal signal that no longer works.

Oil Prices Matter More To The Economy

Unlike the past, the American economy isn’t just affected by oil because of input price changes. The investment in new fracking projects also drives growth. Therefore, a happy medium in prices is the best for the economy. Oil prices need to be high enough to drive investment, but low enough so they don’t weaken demand. However, don’t get overly worried about oil prices staying in a perfect range or sweet spot. One way of looking at spikes in oil prices is that the negative effects are mitigated by the job creation in the energy sector. The U.S. is the 3rd biggest producer of crude oil in the world.

The bigger the sector gets as a percentage of the economy, the higher prices need to be to support the economy. This is a self-fulfilling concept because the higher oil prices go, the more production increases. The chart below shows the historical change in American crude oil extraction. The volatility in production could make the economy more vulnerable to a recession caused by price swings like how the economy almost fell into a recession in 2016 partially as a result of the crash in crude prices. One caveat to this negative thesis is that the fracking market is relatively new. Now that the oil market has adjusted to this new supply, prices might be less volatile. Furthermore, as fracking firms get more mature, they have lowered their costs enough so that they don’t go broke if oil falls. With energy prices expected to go up in 2018 because the end of the cycle is approaching, American economic growth might spike significantly before the next recession. The end of the cycle might be the best part of the business cycle for America from now on.

Manufacturers Taking On More Inventory

I’ve been mentioning a lot of optimistic forecasts, so it’s important to sprinkle in negative theses and reports to show where things can go wrong. The chart below shows the manufacturing shipments along with manufactures’ inventory. As you can see, the inventory never declined as much as the shipments did in 2015 and 2016. Therefore, inventories have gotten way out in front of shipments which is potentially bad news for manufactures’ margins if shipments slip. Manufactures never took the pain that came from the decline in shipments. This could amplify the weakness seen when the next decline demand occurs. On the bright side, demand looks strong. This chart doesn’t mean a problem will occur shortly. Rather it means when a problem occurs, it will be bad for the manufacturing sector. Their margins are already being hurt by wage pressure, so they don’t need another source of weakness. That being said, obviously if the weakness gets bad enough, there won’t be any more wage pressure because layoffs will occur.

Pension Funds In A Bind

You would think with investor sentiment high that pension funds would be going all in on stocks, but the reverse is happening. As you can see from the chart below, public pension funds are pulling back from stocks. You might think that it would great for pension funds if stocks kept going up, but it also wouldn’t be ideal because pension funds are shying away from stocks and wouldn’t share in as much of the upside as you would expect. Shying away from stocks caused pension funds to increase 12.4% in fiscal year 2017 which ended June 30th 2017. That was obviously a great result, but it could have been better. In the future, lower returns than we recently have seen could be a problem considering the underperformance the alternative investments have had.

The chart shows alternative investments made up 18% of investments for public pension funds in 2016 because interest rates are low and stocks have high multiples. The investments included in this grouping are commodities, hedge funds, and private equity. From 2010 to 2016, private equity beat stocks, hedge funds only returned slightly more than 1% and commodities fell. Fund managers are in a tough spot because they need to make 7% to 8% per year while not taking much risk. That’s basically impossible in this market. Wilshire Consulting is predicting 6.25% compound annual returns for stocks in the next 10 years. That’s likely too high since the CAPE is at 32.71 which is the highest point since the 1880s outside of the tech bubble in the late 1990s- early 2000s. There will be serious problems with giving workers the money they were promised if stocks fail to deliver on that projection. The only good news is that interest rates might move up in the next few years. However, there will be pain in stocks and other risky assets before the improvement in yields can boost returns.

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