The Importance of Today's Events Going Forward

There were two developments today that are important for investors to know about before the markets open on Friday to close the month.  

First, and most importantly, the results of the OPEC meeting are the most negative outcome for prices.  OPEC, which over-produced in October, decided to roll-over the existing quota 30 mln barrels a day.  We had noted that the timing of it next meeting would be an important tell.  It did not decide to schedule a meeting in the February-March period, when the seasonal demand slackened.  Instead the next OPEC meeting is for June.  

The market's reaction was immediate.  The price of Brent oil fell almost $5 to slip below $73 a barrel. The price of the US benchmark West Texas Intermediate Crude oil fell 5% to almost $69 a barrel. The IMF estimates that every $10 drop in the price of oil boosts world's growth by 0.2%.  The drop in oil prices can be expected to boost growth by around 0.8% or so in 2015.  

The drop in oil prices transfers income from producers to consumers.  Oil stocks and shares of the energy sector more broadly fell, driven by the sharp drop in oil prices.  The energy component of the Dow Jones Stoxx 600 in Europe fell 3.8% on Thursday, while the broader market gained 0.35%. Confronted with the same shock--the drop in oil prices, the US policy makers will see it in the context of growth while the European policy maker will likely pit in the context of the evolution in prices.  

US gasoline prices are more influenced by the price of Brent than WTI. The average American household spends about $2,000 a year on energy.  The drop in prices of oil and gasoline may be worth $400-$600 a year.   That said, US personal consumption has been amazingly steady, averaging 0.3% monthly rise for 6, 12, 24, and 36 months.  This is being funded mostly through income growth (more than 2 mln net jobs have been created in the first ten months of the year.  Revolving credit debt has barely risen.  

European officials facing weak growth and low inflation seem to be spending mind-share on the latter rather than the former.  The new investment scheme proposed by EC President Juncker pretends that the reason that there have not been more investment in Europe is because businesses.do not have funds or are afraid of the risk.  He is willing to use tax payers money to absorb the first losses.   The drop in oil prices will exacerbate the concern price stability which is often characterized at low inflation.  

This is the second important development.  The preliminary German and Spanish estimates were reported a day ahead of the preliminary figure for the entire euro area.  Germany's preliminary CPI was spot on expectations--flat on the month and up 0.6% on the year.  This is down from 0.8% in October.  Spain's harmonized measure fell deeper into deflation, -0.5% year-over-year from -0.2% in October.  

There is some downside risk to the preliminary eurozone CPI estimate, which the consensus says will slip to 0.3% after 0.4% in October is still reasonable.   The core rate is expected to be unchanged at 0.7%.  

There are two reasons why the threat of deflation is a problem. First is that consumers would pull back further, expected to buy cheaper later.  However, the details of both the German and Spanish Q3 GDP figures did not show this to be the case.   Consumption was a bright spot for both economies.  Of course the situation can change, and it is worth monitoring.   Separately, the money supply and credit figures showed that lending to household for 0.6%, while the contraction in lending to business eased again to -1.6% in October from -18.% in September.  

Second, deflation aggravate the debt burden, with knock-on effects on the creditors via weaker demand, late payments, and higher default rates.  However, interest rates have also fallen and this can help offset some of the impact of low inflation on debt servicing.  There are other ways, such as tweaking the tax code, that the debt burden can be lightened,  

In any event, the point is that the further drop in oil prices and the low preliminary inflation figures will fan expectations of ECB action next week.  Even with these latest developments, we do not envision that a sovereign bond purchase program will be announced.  Insight from a game theory point of view, there is no reason for Draghi to take it off the table.  Ruling sovereign bond purchases out entirely would likely spark a sharp rise in euro area yields and  euro itself.  

Note that Japan reports its CPI figures first thing in Tokyo on Friday.  The risk is that when adjusted for the tax increase, inflation may have dipped below 1.0%.  The recent sharp drop in the yen is likely to boost inflation going forward.  The world's third largest economy imports nearly all of its energy before the nuclear plants come back on-line.  The drop in the yen offsets much of the decline in oil prices, which is a supportive development for Japan.   

We would not read much into the advisers' call on the UAE to re-examine its peg to the dollar.   It proposes linking to a basket of currencies.  Judging from the Treasury's report on the international economy and foreign exchange market, rather than perceive some harm from such a decision, which has yet to be made, the US would welcome the move.  The G7 and G20 have consistently called for market determined foreign exchange rates.  The failure of the oil producers to allow their currencies to appreciate against the dollar is one of the barriers to the global adjustment, though it is rarely discussed.  

Against the major currencies, the dollar had initially softened, amid what appeared to have been some more profit-taking after some disappointing US data on Wednesday.  However, after the OPEC announcement, the dollar recovered and finished the European session on its highs.  Currencies perceived to be linked to oil, like Canada, Norway, Brazil and Mexico were particularly under pressure.   European bonds rallied strongly, with new record lows in many countries.  Greece continued to buck the trend amid reports that is aid program may be extended for through H1 2015.  One problem with this is that it would seem to be a blow to Samaras, who had wanted a clean break, because if he cannot secure a super-majority in parliament to pick a new president, he may have to go to the polls.  Syriza can be the first anti-EMU party to gain the reins of a eurozone government.