Monday 22 January 2018

OPEC - I'm just a soul whose intentions are good...

Halloween pumpkins carved with the likenesses of the two US presidential candidates – the US economy has already shown it’s frightened of a Trump victory
Halloween pumpkins carved with the likenesses of the two US presidential candidates – the US economy has already shown it’s frightened of a Trump victory

Paul Sommerville

While all eyes are on the US election, an even more important event for the long-term health of the global economy will occur towards the end of the month when the Organisation of the Petroleum Exporting Countries (OPEC) meets on November 30.

Back in late September, OPEC surprised the market by announcing its intention to form an agreement to cut production at the November meeting. This was widely reported as "OPEC cuts production" which is not the same thing. Nevertheless the oil price spiked on the news, rising to its 2016 high in mid-October, bringing world stock markets with it. However, oil prices have retraced over 10pc this week as the market is losing faith that an agreement can actually be reached. It is clear the OPEC is pumping at record levels - 34 million barrels per day (bpd) in October - and that Saudi Arabia has even increased production recently from 10.2 million bpd to a record 10.7 million bpd. Many suspect that this is so they can appear to be generous when proposing their cuts.

Previously the main stumbling block to any agreement was that Iran would not agree to any deal as they are in the process of gearing up production. They can easily capture market share at lower prices as they recover from US sanctions. But OPEC members have made a major concession by exempting Iran from any agreement. Unfortunately it seems Iraq, OPEC's second-largest producer with 4.5 million bpd, appears to be backtracking on the verbal agreement.

Regardless of the squabbling, the most important point for investors to focus on is that any agreement marks a huge shift in Saudi Government thinking. They have been pumping at the maximum in order to crush shale competition and try to put high-cost producers out of business. But the policy has not only hurt its competitors but also its own economy. Also, with such vast technological improvements in the industry, producers are able to sustain lower prices with increased efficiencies. Lastly one factor they failed to grasp is that while producers may go out of business their production is simply bought at lower prices by those taking over the debt, leading to no loss of production and the new owners now in a vastly reduced pumping prices - the wonders of quantitative easing and zero interest rate policies.

Today's oil market remains oversupplied by as much as one million bpd and with a November agreement looking less likely, oil prices may struggle short term. But the crucial detail for longer-term prices will be if Saudi Arabia is changing course and abandoning its strategy to force prices lower.

The more cynical analysis would suggest all this talking by Saudi Arabia was a short-term tactic in order to force prices higher for their very short-term ends. Saudi Arabia raised $17.5bn in a record sovereign bond sale, the biggest bond sale from an emerging-market nation, on October 19, the very same day as the 2016 oil price high. Coincidence? I think not. It helped greatly that the oil price had bounced. If Saudi Arabia is changing long-term tactics, then in the medium term oil prices may trend higher but a failure to agree terms in November will put pressure on prices and global stock markets.

Investors may be wise to take the cynical approach when the Saudi oil minister sings: "I'm just a soul whose intentions are good, oh Lord, please don't let me misunderstood."

QE or not QE? That is the really big question

The European Central Bank (ECB) meeting on December 8 is another investors will need to watch. The current round of ECB quantitative easing is set to expire in March 2017, exactly two years from its start date. Until recently the overwhelming consensus of analysts was for an extension with a few alterations added in for good measure. What can beat the "QE is not working - What we need here is more QE "strategy! The ECB is already buying €80bn of bonds per month and in September passed one trillion euro mark. If they want to continue at this pace, they are likely to need to change again the rules governing their purchases.

Any extension beyond March 2017 will certainly necessitate a shift in the parameters of the scheme. This may sound trivial but for investors it may be important, possibly favouring the more peripheral indices such as Portugal and Spain at the expense of more core indices such as Germany's DAX.

But more importantly the mood music seems to be changing and the pressure from the hawkish element of the council - namely Germany - seems to be growing louder. It is possible the ECB, while announcing an extension of the current programme, will also need to announce a "tapering" or slowing of the programme purchases.

Perhaps a gradual phasing out of asset purchases by November 2017 shortly after Germany's elections. In 2013 hints the US would begin "tapering" sent the market into a tailspin and it is probable any hint of similar from Mr Draghi is likely to result in a similar outcome and a very volatile start to 2017 for global markets. The German DAX has traded flat for more than two years, this week trading the 10400 level, the same level it opened 2015; and is some 20pc below its mid-2015 high. Any mention of tapering is sure to put it under further pressure.

Whoever wins, the US economy remains fragile

As the increasingly bizarre contest draws to a close, what is clear is these are perhaps the two worst candidates ever to run for this office - and that really is saying something. The bookies and pundits have Clinton as firm favourite with many suggesting the maths simply do not add up for a Trump victory -some swing states that he needs to win are just not showing the numbers for him, they say.

But with the Brexit result fresh in everybody's mind and the rise of "populist" parties across the globe, there is a nagging sensation these pundits could simply be wrong. The market is expecting a Clinton victory and there may be some relief rallying in stock prices if that outcome occurs. A Trump victory is sure to bring short-term shockwaves and wild swings with selling pressure.

But for investors it is much more important to take heed that the S+P 500, the most widely watched equity gauge in America , is trading at exactly where it was in February, 2015 - 21 months in the doldrums. This bull market is very long in the tooth and stalling noticeably .

Two years ago the Federal Reserve predicted that, by now, the US economy would be growing by 3pc at a minimum and interest rates would be at least 2.5pc. US GDP is likely to be roughly half its estimates in 2016 and interest rates are stuck on 0.25pc. By any standards a dismal failure. Whichever candidate wins, they are unlikely to be equipped to deal with the stalling economy.

So along with the OPEC and ECB meeting, investors will need to monitor closely the Federal Reserve one on December 14. Regardless of who wins the election, the US economy is in a much more fragile state than is commonly reported, and that goes a long way to explain why people are actually voting for Trump.

Next year is shaping up to have potential for increased volatility across all asset classes. The real genius of the quantitative easing shell game is when it eventually fails it will be the voters who will get the blame.

Paul Sommerville is chief executive at Sommerville Advisory Markets

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