Enjoy Low Oil Prices While They Last

The positive effects and sustainability of lower energy prices remain an open question.

Robert Johnson, CFA 31 December, 2014 | 9:16
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Last week I griped that the economic news was amazingly good and no one really cared. With better news out of the Fed, oil prices stabilizing, and even more economic good news, the U.S. equity market bounced sharply off of its bottom. The magnitude of the attitude adjustment was truly stunning. The United States did the best of various country metrics, with the S&P 500 up 3.3% even after having been down sharply early in the week. Europe and emerging markets did half as well, with most up in the mid-1% range. Commodities were down just a touch, and the U.S. 10-year bond rate was a bit higher at 2.18%.

The best of the economic news was a surprisingly strong report on U.S. industrial production. Purchasing manager data also suggested that European production may have stabilized. However, China continued to look weaker. U.S. prices also ticked down, although parts of the report were troubling, including rising rents, rising medical costs, and sky-high beef prices. The housing industry remained stuck in neutral, showing no real signs of a breakout in either direction.

With both retail sales and industrial production--two of the most concurrent economic indicators--showing unusual but sustained strength, it's quite tempting to raise my 2015 growth forecast from 2.0%-2.5% to something closer to 3%. However, with housing and business construction remaining soft and the trade situation likely to worsen with a strong dollar, I am staying put for now. Low gasoline prices could make my conservative stand look silly for a couple of more quarters, but I don't think low energy prices are sustainable for very long. Plus, I think the December employment report will potentially have a negative surprise or two.

Markets Thrilled That the Fed Didn't Seem More Hawkish at Its Recent Meeting
I am not so sure that the Fed really changed much but a couple of words around its stance on interest rates. I am not going into the linguistic exercise of parsing words, but both the old and new wording suggest that the Fed is not in any rush to raise rates. That is why the market rallied sharply after the release. Frankly, if the economy grows faster than expected (the Fed thinks it will grow at a 2.6%-3.0% rate in 2015), it will raise rates sooner. If the economy stalls out, rates will stay low indefinitely. Longer-term, I believe that rates need to be at least above the inflation rate, but demographics and low inflation argue that rates may not need to go that high to be what might be considered normal.

Industrial Production Surprises to the Upside

Strong utility demand and recent employment data presaged a good report on industrial production, and even still results were far better than expected. Total industrial production grew by a very strong 1.3% versus the most recent expectations of just 0.9% growth. Even better, results for the previous months were also revised upward. Stripping out utilities (which are about 10% of the index) industrial production grew by 0.9% in November.

After some up-and-down auto-related issues this summer, the sector has now strung together a stretch of very good monthly performance. The year-over-year data has stabilized at a high level of growth for the manufacturing-only data. Manufacturing has been growing at a 4.5% year-over-year rate recently, significantly above its long-term average of just 2.6%. The strong manufacturing results kicked in before the recent pop in consumption data. I had been worrying that production gains seemed to have a life of their own, regularly besting purchases of goods. It now seems that manufacturers' optimism was not misplaced and that I was too much of a worrywart.

Furthermore, year-over-year comparisons will get easier in the months ahead due to weather issues a year ago. The ISM Purchasing Managers' Report shown in the last column above seems to indicate that manufacturing strength is continuing. I do worry that both export-related and oil-related manufacturing groups could show some weakness in the months ahead, but so far the data has proven to be surprisingly immune to this weakness.

Sector Data Shows Relatively Broad-Based Improvement

As I suspected, the auto sector led the pack in manufacturing, growing 5.1% sequentially and 7.7% year over year. Month to month, autos did twice as well as any other category. Even on a year-over-year basis, autos bested the overall averages, 7.7% versus 5.1% for all of manufacturing.

That said, the other categories weren't too shabby, either. On a month-to-month basis only the "other" category and mining registered declines. Such a short list of decliners is highly unusual. The year-over-year data looks even more balanced as that smooths out some of the monthly volatility. Lately chemicals (a whopping 11% of the index) have been on fire, along with plastics and rubber. We had been waiting for some improvement in these categories because of lower relative energy prices, and the results are finally beginning to show it. Plastics are the single-best performing category on a year-over-year basis, jumping 8.9%. Even the massive chemicals sector showed year-over-year growth faster than the overall index at 5.4%. On the other hand, fabricated metals and aerospace have been relative laggards, probably because of lower defense spending and a stabilization of Boeing's (BA) production rates.

PMI Data Suggests That the World Economy Isn't Falling off a Cliff

The way oil prices are falling, equity markets are gyrating, and various currencies are dropping, one would think the world is moving into another economic recession. However, this month's purchasing managers' surveys from Markit show that this just isn't the case. The early reads on December suggest that overall conditions aren't very different in December from what they were in November or where we were even six months ago. These reports can often react to new conditions very quickly, and so far no one seems to be panicking.

The indexes for the United States and China did slow some, but in the middle of all this turmoil, the data for Europe actually increased. Improvement came in the important new orders and employment related categories. Geographically, the strength in Europe came from some of the smaller players whose PMIs had their best readings in five months. France and Germany didn't do nearly as well.

The China data did move below 50, indicating more firms were seeing declines in activity than increases. A slowing real estate and construction marketplace has been hurting the Chinese index for some time. The current reading is the lowest since May, but isn't really statistically changed much at all. It would take a far bigger swing to worry me. That said, we believe the rest of the world is finally coming to the conclusion that the days of even 7.5% Chinese GDP growth are behind us, and there is potential for growth dropping to as low as 5% over the next five years because of shifting government policies and unfavorable demographics.



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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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