Falling energy prices over the past year are likely to cause drags on energy capital expenditure, but the huge scale of the decline should boost global growth as central banks keep policy loose to stave off deflation risks, predicts Legal & General Investment Management (LGIM).
In the group’s latest Fundamentals briefing, LGIM economist James Carrick assessed the impact of the sharp fall, commenting: “First, an important point – we don’t think that lower oil prices are the proverbial canary in the mine of collapsing global demand for oil. A more likely explanation for the lower oil prices is that the Organisation of the Petroleum Exporting Countries (OPEC) has launched a price war on new technologies, such as US shale.”
LGIM estimates that the US$60 fall in oil prices will directly knock around 1½% off the Organisation for Economic Cooperation and development (OECD) inflation rate through lower energy prices. Its models suggest consumers will spend half of this and save the other half, resulting in a boost to real consumer spending of around ¾% (equivalent to around 0.4% of world gross domestic product (GDP)).
“A further boost should come from the broader corporate sector,” said Carrick. “However, we don’t know how the corporate sector will react to the cost savings, and whether these may be passed on to end consumers, through airfare cuts for example.
“If companies don’t pass on lower prices, then profit margins should rise which could boost financial markets through higher dividends, share buybacks or merger and acquisition (M&A) activity.”
LGIM notes that not everyone will benefit from the decline in prices. Weaker energy capital expenditure is inevitable with the US shale industry and oil producers such as Venezuela and Russia, at risk. There is also the risk of defaults on loans to energy companies in the US and UK. While this should be offset by increased profitability of the non-oil sector, a concentrated shock to one sector could hurt banks, triggering a tightening of credit conditions.
A further danger stems from deflation. A prolonged period of negative headline inflation, alongside low core inflation as firms pass on the US$1.1trillion of cost savings, could dampen inflation expectations and therefore wage negotiations as we head into 2016. This could ‘lock in’ low inflation
“In the near term, while there are offsetting drags from lower energy investment and weaker demand from oil importers, the consumer sector is likely to be red hot as a result of too cold inflation and lower-for-longer interest rates” added Carrick.
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