|»5 Minute Wrap Up by Equitymaster|
On This Day - 3 FEBRUARY 2016
Why Are Stock Markets Worried about Low Oil Prices?
My aunt asked me a smart question the other day: Why are stocks falling because of plunging oil prices? Aren't low oil prices actually a good thing?
Probably. But as always with oil, things are a bit more complicated than they seem.
For the last 75 years, the culprit behind 'oil shocks' has usually been high - not low - oil prices. The series of oil shocks in the 1970s is a classic case in point. In 1973, Arab oil producers imposed an embargo, which caused crude prices to spike from US$3 to US$12 per barrel in 1974.
That high oil prices cause shocks to the economy is understandable. Pressure on government finances mounts (especially for oil importing countries). The high prices eat into disposable income. Consumption takes a big hit.
So when the reverse happens, as it is now, why do markets react negatively? An article in Newsmax tries to explain this.
In the last several years, more so since the 2008 global crisis, the emerging countries have come into the spotlight because of their high-growth potential compared to the developed world. As growth in the rich Western countries has slowed, many global companies have relied on emerging markets to shore up overall performance. Barring India and China, many of these countries are oil and commodity exporters.
So the rout in oil as well as other commodities has wreaked havoc on the emerging countries, thereby denting the earnings growth of major corporations. Indeed, the world's economy relies far more today on emerging countries than it did 15 or 25 years ago. These economies now account for nearly 40% of global GDP, about double their share in 1990, according to the International Monetary Fund.
The plunge in oil prices, therefore, has severely restricted growth in these emerging countries. And now we have a situation where the rich world is not growing and the emerging world is slowing.
The other big change in the oil landscape is the US. The boom in shale oil production in the country has the US vying with the Middle East and Russia as the top oil producer. This was not the case a few years ago.
Now, the major argument in favour of low oil prices is the boost in global consumption. So far that has not been happening at the pace envisaged. For instance, in the US at least, so scarred is the average American by the global credit crisis, that any savings from low oil prices are being used to retire debt rather than go on a consumption spree.
India and China, the two biggest oil guzzlers, are not seeing a drastic pickup in consumption just yet. China's economy is in fact slowing and demand has waned. The Indian economy is also yet to pickup in a big way.
What does all of this mean? Only that there are too many factors that influence the movement of oil prices. And that's why we never claim to be experts on where oil prices are headed next.
Our broader view is that oil prices are not sustainable at such low levels for a long time because it doesn't encourage the kind of investment the industry needs. The long-term trend suggests that oil prices will average somewhere around US$60-65 a barrel with many spikes and plunges along the way. We believe this is the best approach for a commodity as complex and vital as oil.
3:03 Chart of the day
Stock markets tend to react to every bit of information either on the micro or the macro front. And most of the time, such swings hardly make sense. One such economic event, which influences market movements is the announcement of Monetary Policy.
Markets reaction to change in Monetary Policy
As seen in today's chart, when the RBI announced a rate cut, the Sensex gained. But when the RBI maintained status quo, the Sensex did not always react positively.
But as a serious long term investor, such market movements should not bother you. As we have discussed many times in the past, such policy decisions should not impact the way you go about investing.
Investors should bear in mind; monetary policy is nothing more than a liquidity management tool for the central bank. And should be perceived as a signal of the broader macro trends. When it comes to investing in stocks, the focus has to be on the soundness of the business model, management quality and reasonable valuations.
As reported in today's Economic Times, the Indian government is in the process of announcing a mammoth outlay of Rs 1,300 billion, under the National Food Security Act (NFSA). This is double the number allocated in current year's budget. Reportedly, Food Security Act is expected to come into force from April 1 and will cover more than 70 crore beneficiaries across 27 states and union territories.
Two issues are often discussed when such big bang announcements are made. One, will the actual beneficiaries get what is intended for them? And two, will the government be able to fund the planned allocation?
Let's take the first issue. The government has been taking various steps to ensure the policy is implemented and the beneficiaries gain from the Act. So far, programs such as these have been the hotbed for corruption. So it will be interesting to see how the government chooses to tackle this issue.
Coming to the second aspect, in our view the plunge in oil prices seems to have given some leeway to the government when it comes to its finances. This is despite the poor agricultural production caused by erratic rainfall.
But is that enough to fund the allocated expenditure without putting excess pressure on the Budget bill? That is the big question.
After opening on a weak note, Indian markets have continued to languish in the red. At the time of writing, BSE Sensex was trading lower by around 200 points. All the sectoral indices were witnessing selling pressure, with stocks from power and realty facing the maximum brunt. Stocks from both the smallcap and midcap spaces were not spared either. The BSE Midcap and BSE Smallcap were trading lower by 1.3% and 2% respectively.
Editor's Note: Noted economist Mr Savak Sohrab Tarapore, who wrote the column Common Voice for Equitymaster, passed away today. May his soul rest in peace.
4:55 Today's investment mantra
"What we learn from history is that people don't learn from history." - Warren Buffett
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