Chinese inflation continues its downward trend according to published numbers this morning, and producer prices remain entrenched in negative territory, as the disinflationary impact of the real estate slowdown persists. Looking at the global impact of what’s happening in China, we see the other side of the two fold reason for pressure on oil prices. We’ve talked about the supply side, with the Shale gas revolution in the United States eliminating US energy dependency on OPEC (indeed we expect the United States to become a net energy exporter!), but we also have the demand side with China the huge energy importer requiring less oil in a slowing economy. When you consider the near future the demand side looks to be more at risk at the moment. Yes, if oil prices go much lower, many of the higher cost producers in the U.S will probably have to slow production down significantly – my understanding is that production costs range from as low as $40 to as high as $90. Already we have so called extreme oil bears, talking about $40 crude oil, it must make OPEC members shudder! I don’t want to bore you, but the likes of the Russian rouble and Nigerian naira continue to hover near their year to date (and record) lows, this will continue until there some respite for energy prices.
Looking at the major currencies, yesterday brought respite from the dollar trend with currencies like the euro, Japanese yen and pound sterling strengthening versus the greenback. As I mentioned then, we are now at interesting levels in the dollar trend, I have observed signs of momentum extremes and divergences…. What does this mean? It means that there is a very real risk of the dollar correcting lower (at least versus the other major currencies) in the near term. This certainly doesn’t mean an end to the bull trend, but the move could be of reasonable significance. The frustration is though, that the possibility also exists – in a powerful trend – for a continuation higher for the dollar, I really don’t know where we go from here. One of the key levels I am monitoring now is 1.2344 in EUR/USD, if we can hold above this level today then my conviction of a dollar correction will increase somewhat. However if we go through this level, then from an Elliott Wave Theory perspective, the risk is that we make new lows with the possibility of another 4 – 5% decline. This is what we’re talking about, we’re at key levels that could imply 4 – 5% moves either way. On the horizon the only event I can see that will provide us with enough impetus, one way or another, is the FOMC meeting on Wednesday 17th December. There isn’t much to look forward to data-wise today.
As I mentioned yesterday I didn’t see much reason for sustained falls in equity prices despite the frothy price action in China; and the bear market conditions in some of the more oil rich developing market bourses, and sure enough we saw some recovery in US equity prices. I would expect this to continue into yearend, absent of any earthquakes from next week’s Federal Reserve meeting. Book squaring and performance chasing are likely to be the name of the game in the final weeks of 2014.
I made some comments about corporate debt in developing economies in yesterday’s blog, so I had better follow up on that. Over the last few years, large companies in emerging markets have taken advantage of the zero interest rate environment in major economies and borrowed at cheap rates. By some measures, the exposure is in the trillions of dollars. And here we are now in 2014, with the dollar having appreciated strongly against many of the home currencies of these corporates. For some of these corporates, times are surely getting tougher, particularly if they are not multi-national companies earning a substantial amount of their revenues in dollars or at least in currencies that have been able to hold their value versus the greenback. Why is this a problem? Consider an imaginary Russian company that borrowed dollars – which by the way would have been an entirely reasonable thing to do if you could pay loan rates of 5% for US debt why borrow at 15% in Russia? – those loans, given the roubles 80% devaluation versus the dollar are now 80% larger. If that’s not bad enough the Russian economy has slowed down substantially, so you’re hit by a larger debt burden and slowing revenues. This type of scenario might be more common than we think, and events like this were responsible for the Asian crisis in 1997 and the Tequila crisis in Mexico in 1994. I certainly don’t have enough specific data to identify the economies where these sorts of corporate risk are significant, but we all need to be vigilant. The times were too good folks. If you have a party with cocktails and champagne flowing freely, don’t be surprised when some people have hangovers the next day!