Exploring the Economic Landscape

Recently, the oil market has been closely tied to how the economy performs – with traders using the S&P 500 as a proxy for overall economic activity. Because the economy has become some a dominant part of the oil price narrative, today’s FUELSNews focuses on the top three threats to the global economy – Interest Rates, Trade Tightening, and China’s Growth.

1. Interest Rates and the Boom/Bust Cycle

The current bearishness hitting the stock market and other economic indicators is largely driven by interest rates. Interest rates are one of the most important factors affecting economic performance. One of the greatest hedge fund managers of all time, Ray Dalio, explains in a helpful animated video (I’d encourage you to invest the 30 min to watch it) that interest rates impact available credit, which in turn drives the boom and bust cycle we all know as expansion periods and recessions.

Low interest rates make it easy to borrow money – more money, more spending. That spending drives economic growth – the expansion period. At some point, though, interest rates become too low, and inflation kicks in (caused by too much available money). The Federal Reserve manages interest rates by setting the base lending rates to banks, lowering them to drive economic activity and raising them to curb inflation.

Higher interest rates make borrowing more expensive, meaning less money available for purchases. Right now, the Fed is hiking interest rates, sometimes called “deleveraging” because buyers have less available credit (leverage) to buy goods.

Added to the interest rate hikes is quantitative tightening. You may remember back in 2008 when the Fed chose to start buying trillions of dollars in government bonds and mortgage backed securities. Basically, the move injected more cash into the financial system (because the Fed gave money to the government and banks in exchange for those bonds), and more cash means more spending! Now, they’ve stopped buying, so the government and banks are having to find other investors to buy their bonds – leaving less leftover cash for consumption, and less cash means less spending.

Between higher interest rates and quantitative tightening, the economy is taking a double-hit. There’s less credit and less cash available, meaning spending has to come down. That’s why the stock market is taking such a hit right now – less excess spending money means fewer iPhones sold, fewer new cars driving off the lot, less companies advertising, etc. Ultimately, that reduced spending will translate to less fuel demand (lower prices), fewer job opportunities, and a potential recession.

2. Global Trade

In addition to tightening interest rates and quantitative tightening, global trade has been slowing as countries are implementing protectionist policies. Leading the charge here is Donald Trump, who has famously challenged conventional wisdom on trade. Trump has put numerous new tariffs in place, ranging from product-specific tariffs on aluminum and steel to country-specific tariffs on China.

Global trade is deflationary, meaning it causes prices to go down – something global consumers love! Imagine that China can produce the cheapest electronics, Florida produces the cheapest oranges, and Japan produces the cheapest cars –global trade allows consumers to buy from the cheapest country in each category. Less money spent on required daily goods – food, fuel, shelter, etc – means more money left over, and as we said above, more money equals more spending!

Trade barriers halt this low-cost opportunity. Tariffs on China, for instance, make electronics more expensive for American consumers, meaning they have less money left over to spend on other products. Now, tariffs do have some counter-benefits – those higher prices allow domestic companies to compete and thrive while making larger profits. Those profits still equate to more spending (and therefore economic growth), but at the expense of domestic consumers and the other country that can produce cheaper.

Putting that in context of American tariffs – steel tariffs drive more business to American steel producers, but also create difficulties for the users (pipeline companies, automotive manufacturers, etc). Tariffs on China benefit US manufacturing as well, but translates to more expensive products for consumers and a severe hit to the Chinese economy. Tariffs are generally neutral or slightly positive for the company implementing them, but bad for global growth.

Those foreign businesses that lose out on business have less cash available, meaning they cannot stimulate their own local economies. In the example of US-China tariffs, Chinese businesses are making fewer sales now, leaving them with less money to buy American goods as well.

3. China Economy

With nearly 1.4 billion people and a $12.2 trillion economy, China’s economy is now nearly as integral to the global economy as the US. Still developing rapidly, China’s hefty 6.9% GDP growth last year was nearly 3x the size of America’s GDP growth of 2.3%. The US’s Federal Reserve, which is required to evaluate only the US economy when making decisions, referenced China many times in their November note, making clear the importance of China’s economy on our domestic growth. Given its massive size and rapid growth, any hiccup in China’s growth has repercussions for the entire global financial system.

Reliably measuring China’s economic activity is difficult given government data controls, but some indicators point to declining growth. China’s Shanghai Composite Stock Market Index has been declining lately, weighing on global equity markets. Official data shows a general year-over-year slowdown of retail sales and industrial activity.

The US-China trade war has weighed heavily on China’s economy. China is an export economy – much of their growth is driven by exporting goods to other countries, and the US is the largest consumer in the world. Losing out on a top customer means fewer sales, and less money available to spend. That slowdown has an outsized effect on China’s economy given their reliance on exports. Trump is correct about one thing – tariffs hurt China more than they hurt the US, and domestic pressure has been building up for the Chinese government to give in to trade negotiations.

The Chinese government is targeting 6.5% growth for 2018, a downward revision from last year. Some fear this number may still be too aggressive, calling for lower growth around 6.3% or less (a difference of nearly $25 billion). Such weakness would weigh heavily on the global economy. If the US-China trade war continues to escalate in 2019, China could see a very poor performance in 2019.

Conclusion

The global economy is in a precarious place right now. With interest rates rising and federal banks tightening their balance sheets, there’s less cash and less credit available to consumers. At the same time, protectionism is curbing global trade, driving prices higher at a time when consumers are already cash-strapped. One of the largest contributors to global growth, China, is already experiencing weakness.

As the economy tightens and activity declines, the impact to oil prices should not be overlooked. Economic slowdowns mean fewer trucks transporting goods, fewer barges shipping internationally, and fewer consumers driving and flying to vacation destinations.

The aggregate effect contributes to a significant reduction in oil demand, but the affect is not one-for-one. Six percent global growth does not require a commensurate 6% increase in oil demand. That’s because developed economies like the US and the EU can add economic growth without more fuel – for instance, Netflix doesn’t use fuel to deliver more online products!

On the other hand, developing countries in East Asia and on other continents are more energy intensive. China grows by moving more products to other countries, requiring fuel to get it there. Agrarian economies need fuel to grow more crops, and fuel to transport them to other countries. When those developing nations slow down, there’s a significantly larger impact on fuel demand than if the US experiences a slowdown. For that reason, all eyes are on China and emerging economies in 2019 – if those countries cannot pick up the economic pace, oil demand may decline, causing prices to plummet.