Recap 07-27-15: It’s Nominal

I’ll be away for a couple weeks, so I wanted to share a few thoughts before I head out.

First, I think the importance of oil as a driver of all major nominal asset prices this year remains under appreciated. Here are a few charts comparing major asset prices vs the 1y1y forward WTI oil strip:

Oil vs S&P

10y vs Oil

HY Spreads (Barclay’s HY OAS, inverted) vs Oil:

EUR vs Oil (since Jan here, post ECB QE meeting)

This makes sense of course. Financial assets are priced in nominal terms, so to the extent that inflation expectations fall sharply, it shouldn’t be a surprise that nominal return expectations also fall. 1y fwd inflation swaps have declined from a high of 1.76% to just ~90bps. That is still a far cry from the -32bps from this January, but the magnitude of the drop remains very fast by historical standards.

In addition to the impact on yields, the drop in inflation expectations have also resulted in a fall in expected SPX earnings. The deflationary impact from commodities prices is quite significant. My estimate of consensus earnings expectations now shows a negative YoY print. This is probably the biggest surprise to my expectations from Dec. In addition to this, the rise in credit spreads is pressuring risk premiums wider across the capital structure. The chart below highlights this, show how the Barclay’s US Credit Avg OAS is now just below ~150bp level that has historically coincided with recessions and periods involving systemic shock.

How much more downside for oil is thus a key question for near term nominal financial asset prices. Forward markets suggest that the Iranian deal has had a substantive impact on the marginal cost of production. 1y1y fwd strip in WTI has broken below January lows, and continues to fall. How far it can go is anyone’s guess at this point, but it should not be a surprise if we do wind up seeing new YTD lows for spot crude prices. Having said that, my naïve read of positioning data suggests that there is some chance of a bottom in the near term.

BUT let’s take all of that into context. While oil prices are certainly affecting near term nominal expectations, ultimately the effects will be contained, if for no other reason that that there is a limit to how low oil prices can go. By January next year, the vast majority of the base effects will have filtered out from market calculations, even if spot oil prices do fall sharply from here.

With respect to longer term factors, here are a few things I see:

The effect of base effects on inflation means that the Fed may delay its first hike, then hike more aggressively, inline with the eventual jump in inflation to more normal levels.

EMU leading indicators are getting stronger and stronger, recent PMI prints notwithstanding. This is likely to provide further support for the EUR vs the dollar, ceterus paribus. But it will also provide solid support for EU equities, the currency effects notwithstanding. My model projections for consensus estimated earnings growth for the Eurostoxx 50 index has ticked up to +12% through year end, non-annualized. Note that the MSCI EU ex-UK index is at the cusp of breaking 15 year highs: (Recall that the SPX broke through in March 2013)

In an even longer context, current EMU travails are very comparable the post revolutionary US period. The Alexander Hamilton biography by Chernow (which I am reading based on a suggestion in a Michael Pettis post) is excellent, and provides many parallels.

I’ve expected Gold to fall for a long time now – see post on 1/14/15. I expect another 10% downside over the next couple years at a minimum, though spec positioning suggests a potential near term bounce.

Interesting food for thought: