Tuesday, December 2nd, 2014

Lucky Generals

Napoleon famously wanted his generals to be lucky. They could march in the wrong direction, and use the wrong tactics, but so long as the enemy made more mistakes, he did not care. For a long time we have thought that the ECB was using the wrong tactics to lift the Eurozone out of the crisis. But now we think that Mr Draghi and his peers may be just about to get lucky. A significant and sustained fall in oil prices could be a major boon to the Eurozone, particularly when combined with the right sort of monetary stimulus.

The most important model in current circumstances is our country rotation model (country clock) which measures the probability of individual countries producing superior risk-adjusted returns vs the rest of the global equity market. In addition to measuring the current situation we can observe how much it has improved over the last month, and estimate how much it is likely to improve by looking at the slope of the probability curve. (See our website: www.harlynresearch.co.uk/process/ for more information). No matter which metric we look at, all of the countries in the Eurozone have improved their position over the last four weeks. The biggest improvement comes in the forward-looking indicator i.e. the slope of the probability curve.

This could just be a delayed reaction to all the speeches Mr Draghi has made in recent weeks, but the improvement has been particularly strong in the last two weeks, which is when investors first began to believe that there was going to be a major shift in oil prices. The biggest improvement (in equities) is concentrated in countries such as the Netherlands, France and Germany where there was likely to be little ECB intervention, rather than Italy, Spain or Portugal which would have hoped to benefit disproportionately from a programme of sovereign bond purchases. The other point is that all the Eurozone countries have benefitted and none have lost, whereas of the rest of the world has either not benefitted or not benefitted as expected.

Our interpretation is that investors are becoming enthusiastic about the combination of increasing monetary stimulus and falling oil prices. The combination is not unique to Europe. Japan also benefits, but Japan is in the middle on an election campaign, where there is a risk of significant fiscal tightening if the wrong result is delivered. The US benefits from falling oil prices, but this may embolden the Fed to raise interest rates earlier than expected. The UK is net neutral regarding oil prices, and most emerging markets suffer from the impact of a strong dollar, even if they are not oil producers.

The combination is much more powerful than either stimulus on its own. We believe that a programme of sovereign bond purchases will do little to stimulate demand for credit or improve the willingness of banks to lend without some form of credit enhancement. Falling oil prices will improve business confidence, but may not produce second order effects on growth unless they are given full fiscal and monetary accommodation. The happy combination could still go wrong. The euro could fall too much against the dollar so that consumer prices are unchanged in euro terms or governments could get greedy and raise excises taxes. But provided these two fairly obvious dangers are avoided, Mr Draghi may be looking at an annus mirabilis in 2015.

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