The Collapse of Oil Price: Threat or Chance?

The Collapse of Oil Price: Threat or Chance? February 216 PERSPECTIVES Key Insights Monica Defend Head of Global Asset Allocation Research Other Contributors Global Asset Allocation Research Team Edited by Giuseppina Marinotti Financial Communication Specialist Claudia Bertino Head of Financial Communication Team The decline in oil prices is, in our view, mainly a consequence of a supply shock, but the lack of strength in global growth and the transition of China toward a more mature economic model has clearly contributed to widen the gap between supply and demand. If, as we believe, there will be a stabilization of supply/demand dynamics and the scenario of slowdown, but no hard landing, for China holds, we see oil prices gradually returning to 45-5 USD per barrel by the end of 217. With this outlook for oil, the global economic outlook remains moderately positive. The main implication is lower inflation expectations, which will likely trigger a new wave of monetary policy intervention. In terms of winners and losers, we see a neutral impact on the US economy, with the benefit of higher disposable income almost counterbalanced by lower investments, and a slightly positive effect on the Eurozone. On Emerging Markets, lower oil prices (and lower commodity prices generally) increase the dichotomy between exporters and the importers who are enjoying the oil dividend. Financial markets have framed the slide in oil prices more as a demand-side shock (with negative effects), than a supply side shock. Since the beginning of the year, the correlation 1 of all assets with oil has increased substantially and equity markets have traded very closely with oil prices. We believe that the recent market selloff has generated price dislocations that could offer interesting opportunities for investors. Yields have been pushed well above the 1 year average 2 on the riskier segments of the credit market (particularly in US High Yield where the energy component weighting is about 1%). Markets are incorporating an Armageddon outlook for the energy sector, which is not likely in our view. A re-rating of inflation expectations has hit inflation-related assets (i.e., bond linkers), and now discounts a very negative outlook. We believe that the market is underestimating the inflation pressures that could come from wage growth (in the US), and therefore we believe that opportunities may open up in the linkers segment. The potential positive effect of an oil supply shock is not straightforward: it depends on its length and depth. The prolonged slide in oil prices to early 2s levels has in our view profound implications for the economic outlook and financial markets. In this piece, we try to answer some of the key questions that the oil weakness has raised, with a specific focus on investment consequences. 1. What Forces are Driving Oil? In order to assess the effects of oil price swings, we believe it is important to first look at the forces behind them. In a simplified world, we could say that an oil price decline driven by excess supply should be positive for economic growth as 1 The degree of association between two or more variables; in finance, it is the degree to which assets or asset class prices have moved in relation to one another. Correlation is expressed by a correlation coefficient that ranges from -1 (never move together) through (absolutely independent) to 1 (always move together). 2 Source: Bloomberg, data as of February 22, 216. 1

disposable income rises and, consequently, demand for consumption and investment increases. Headline inflation would temporarily drop but core inflation would stay resilient. As the base effect of lower oil prices is absorbed, headline inflation should revert to pre-shock levels. However, even in the case of a supply shock, grey areas would emerge. If, for example, the shock is prolonged or repeated, inflation expectations would tend to incorporate the decline in oil prices. As price and wage settings are a function of inflation expectations, we could see a negative impact on core inflation as well. Investment decisions and growth would be negatively affected. An oil price slump driven by globally weaker demand would probably not be growth friendly declines in net exports, lower investment and spiraling deflationary forces would put further pressure on growth. In the current economic framework, we can identify the presence of both a supply shock (which seems to be dominant) and a demand slowdown behind the oil price decline. In the current economic framework, we can identify the presence of both a supply shock (which seems to be dominant) and a demand slowdown behind the oil price decline. With OPEC so far determined not to cut production and Iran pumping additional barrels into the market as sanctions have been lifted, there is more oil being supplied than the market can absorb. Added to this is the wave of production from the US energy revolution, which has lowered oil imports over the last decade. U.S. Imports of Crude Oil and Petroleum Products (Thousand Barrels per Day) 16 14 12 1 8 6 4 2 1973 1976 1979 1982 1985 Thousand Barrels per Day 1988 1991 1994 1997 2 23 26 29 212 215 Source: EIA, February 17, 216. Another factor to consider is not only the excess of oil supply but the prolonged excess of supply over time that poses problems with respect to physical storage, putting pressure on spot prices and the forward curve. Fears of an excessive Chinese slowdown weighed on the last leg of the oil price correction. If demand shocks are not the main culprit of the oil price decline, in our opinion, the lack of strength in global growth has clearly contributed to widen the gap between supply and demand. In particular, China s slowdown has been one of the most important contributors to the weakness of oil (and commodities) prices. China s evolving economic structure is moving towards domestic consumption and away from heavy manufacturing and exports, marking a structural change for future demand. Such developments affect oil prices, but more so metal prices. 2

The fear of a stronger-than-expected deceleration of Chinese growth at the end of 215 has led the most recent wave of oil declines, almost halving the price between the summer and the January lows. China Rebalancing Weighting on Oil and Metal Commodities Prices Index rebased at 1 Q1 24 5 4 3 2 1 2 15 1 5 % Chinese Secondary Sector (RS) Base Metal Index (LS, Rebased) Brent Price (LS, Rebased) Source: Bloomberg, CEIC, Pioneer Investments, as of February 17, 216. If, as we believe, there will be a stabilization of supply/demand dynamics and a slowdown, but no hard landing, for China, we see oil prices gradually returning to $45-5 USD per barrel by the end of 217. Looking ahead, we see some stabilizing forces for oil prices coming with the gradual closing of the supply and demand gap in 217 (a reduced pace of growth in oil supply mainly driven by non-opec producers and a gradual post-sanction return to full capacity by Iran) and draw on oil inventories in the second half of 217 3. World Liquid Fuel Production and Consumption Balance (Million Barrels per Day) Mln Barrels per day 1 98 96 94 92 9 88 86 84 82 3, 2,5 2, 1,5 1,,5, -,5-1, -1,5 Mln Barrels per day Oversupply (right axis) World consumption (left axis) World production (left axis) Source: EIA, February 16, 215. If our central case of China transitioning relatively smoothly and avoiding a hard landing materializes, we expect the demand for commodities to keep growing in 216, albeit at a slower pace than in the past. Partly offsetting the Chinese slowdown, if US and European economies remain resilient, this could give some support to oil demand, and help to gradually reduce the overcapacity gap. Note the outlook for the US is to reduce the amount of oil it supplies to the market. In this scenario we see the possibility of a rebound of oil towards 45/5 USD per barrel by the end of 217. 3 See also EIA outlook, February 216. 3

West Texas Intermediate (WTI) Crude Oil Price (dollars per barrel) 8 6 4 2 Historical spot price STEO price forecast NYMEX futures price Source: Short-Term Energy Outlook, January 216, Pioneer Investments. STEO means short term energy outlook. As a consequence of falling oil prices, we have marginally revised down GDP forecasts and inflation expectations. 2. Impact on Growth and Inflation? If we include the above scenario for oil prices, our outlook for the global economy remains moderately positive. Although revised marginally down, our world trade forecasts (and implicitly our assessment of a recession probability) remain benign; we do not see a collapse in world trade following a sharp contraction in any major country, particularly in China. In our opinion, the excess supply story had a substantial role in the oil correction, so we may expect some support on demand especially for consumption (this is already visible in countries with higher elasticity of consumption to disposable income). Contribution to Global GDP Growth 6 4 Global Growth with Forecasts 2 % -2-4 BRIC Other EM EU (UK included) US Other DM Source: Bloomberg, IMF, Pioneer Investments, Thomson Reuters Datastream. Data as of February 22, 216. We believe economies that are increasingly relying on the service sectors (typically Developed Markets) rather than manufacturing or natural resources, and are less linked to commodity and oil prices, are generally more resilient to the downturn in commodity prices. On the inflation side, lower oil and commodity prices have contributed to further lowering the inflation path. Inflation-related market indicators (inflation swap forward 5Y5Y) indicate that headline inflation is perceived as likely to stay low, which makes the central banks goal of keeping inflation expectations anchored quite challenging. However, it is worth noting that core inflation (which excludes energy and food) is gradually recovering, although more so in the US than in Europe. 4

Falling Inflation Expectations, Especially in Europe % 3,2 3, 2,8 2,6 2,4 2,2 2, 1,8 1,6 1,4 1,2 US inflation swap forward 5Y 5Y EU inflation swap forward 5Y 5Y Source: Bloomberg, Pioneer Investments, data as of February 16, 216. 3. Who are the Winners and Losers in the Oil Price Plunge? Oil prices have declined about 5% since the summer of 215. The immediate consequence of such a move is a wealth transfer from oil exporting countries to oil importers. The net impact on the US economy of lower oil prices should be neutral, with the positive impact on disposable income offset by lower investments. In the US, the scenario in which oil prices are lower but do not follow a persistent downward spiral strengthens the case for a resilient Personal Consumption Expenditure as the main contributor for growth. In fact, we expect consumption to benefit from higher real disposable income (coming from mild wage increases and lower projected inflation rather than from further strong gains on the employment side). We expect some downside pressure on the outlook from Investments in energy related sectors and manufacturing sectors, and also via weak export performance. Stressing our forecasting model for a persistent 1 USD drop in oil prices (oil prices remaining around 3 USD/bl persistently over the next 8 quarters) would leave GDP growth almost unchanged, as the improved consumption growth would be offset by lower investments growth. On inflation, persistently low oil should drive a.4% YoY fall of headline CPI in both 216 and 217. In Europe, the decline in oil prices is expected to bring further fuel to private consumption that was the main engine of Eurozone growth in 215. We also expect a positive contribution to growth from investment, triggered by the lower oil price. While declining oil prices act as a drag on inflation in the Eurozone, the sensitivity of auto fuel prices (the one directly perceived by customers) to falling oil prices is probably overestimated. 5

The Eurozone should receive a net benefit from persistently low oil prices. Change in Brent Crude Oil Prices (Loc. Curr.) and Auto Fuel Prices (Dec 212 to Dec 215) Price Change (%) -1% % -2% -3% -4% -5% -6% -7% -8% -9% Auto Fuel Change Crude change Source: Pioneer Investments. Datastream data as of January 28, 216. If we engage in the same exercise for the US, an average 1 USD/bl move lower for oil prices than in our central case scenario for 216 ceteris paribus would further impact inflation, by lowering our projections over 216 by.2% YoY on average. GDP, Personal Consumption Expenditures and Gross Fixed Capital Formation should be impacted positively, in both 216 and 217, instead. In Japan, the growth outlook is quite weak. However, GDP growth in 216 should be driven more by internal demand components, such as consumption and investment, in contrast to the poor quality of growth seen in 215, when.5% out of.7% of GDP yearly growth was contributed by Inventory accumulation. Stressing the model for the 1 USD oil price decline, ceteris paribus, would lower GDP mainly because of the drop in investments, and would lower the inflation path. We continue to expect a mild positive trend going forward, but inflation will remain increasingly distant from the Central Bank's target of 2.% YoY. In EM, the first visible impact of the collapse in oil price has been a deterioration of the overall outlook: the not-so-rosy picture provided at the end of 215 has weakened a bit further, exacerbating the dichotomy between commodities/oil exporters and net importers. The chart below gives a clearer picture of the countries enjoying the oil dividend and the countries suffering from depressed oil prices. Oil Net Balance (Export Import) on GDP Russia Colombia Mexico Malaysia Brazil Australia US China Indonesia Turkey Japan Philippines Hong Kong Chile India South Africa South Korea Thailand Taiwan Net Exporters Net Importers 15,% 1,% 5,%,% -5,% -1,% Source: Pioneer Investments. Morgan Stanley data as of December 31, 215 6

We have identified two main themes relevant from the perspective of EM economies, inflation and fiscal balance: Inflation developments are mixed and reflect, on one side, weaker domestic demand and lower commodity prices and, on the other side, the effects of currency depreciation through imported inflation. Countries facing the risks of excessive currency depreciation and capital outflows may have limited scope for future monetary policy easing to boost the economies. Commodity exporters are facing a shortfall of revenues; the challenge for them is to adjust their economies to lower commodity revenues improving fiscal efficiency, increasing revenues from different sources without making drastic cuts in expenditure which could exacerbate the damage to their economies. Financial markets overreacted to the fall in oil prices, reading it as a demand-side shock. It is worth adding that in addition to oil other commodity prices are at historical lows as well, making the group of countries expected to benefit from the oil collapse less crowded. From this perspective, other countries at risk are South Africa, Chile, Indonesia, Australia, Brazil and Malaysia. 4. What are the Investment Implications? We have observed that financial markets have framed the slide in oil prices more as a demand-side shock (with negative effects), than a supply side shock. In recent weeks, correlations of all assets versus oil have increased substantially and equity markets have traded very closely with oil prices. Correlation of US Equity and US 1 Y Treasury versus Oil 6% 4% 2% % -2% -4% correlation equity vs oil correlation US yield vs oil Source: Bloomberg, data as February 8th 216. S&P5 index considered. We believe that the market selloff has generated price dislocations that could offer interesting opportunities for investors. It has pushed up yields in the riskier side of the credit market i.e., US High Yield where the energy component weight is about 1% well above the 1 year average, to levels that incorporate a very negative scenario for oil prices. This price action has also affected the EM universe, with bond yields reaching five year highs (Source: Bloomberg, February 17, 216, JPM EMBI Global Blended Index). 7

US High Yield Yield to Worst 4 25 2 15 % 1 5 Source: Bloomberg, data as of February 16, 216. Barclays US Corp. High Yield. We believe that price overreaction in credit markets and inflationrelated assets is opening up selective opportunities for the long term. Indeed, the energy sector has been hard hit by the fall of oil prices and the default rate is expected to rise in 216 from 3.4% in 215 (Source: Fitch, January 26 216) as many of the high-yield oil companies cannot operate profitably with oil below the 5 to 7 USD barrel range. However, we believe the market is now discounting an extreme situation in terms of defaults: assuming that the oil price remains close to current levels over the next five years, which is not our main scenario. (Read also Outlook Update for US Asset Classes, January 216) Additionally, the spillover effects on other sectors should remain contained. The energy sector now accounts for a small share of total US employment, after declining consistently since the 8s, and the sector s share of GDP is quite limited. If our macro scenario holds (oil price stabilization, China slowdown but no hard landing, very slow normalization of Fed policy and relative resilience of US economy) the recent selloff can provide opportunities to investors, especially in terms of income. We should, however, acknowledge that volatility is expected to remain very high, and therefore we believe a long-term approach is needed. At the same time, a re-rating of inflation expectations has hit inflation-related assets (i.e., bond linkers), which now discount a very negative outlook. We believe that the market is underestimating the inflation pressures that could come from wage growth (in the US), and therefore we believe that opportunities may open up in the linkers segment. On the Central Bank side, we see a more dovish tone overall (compared to our outlook at the start of the year) driven by a weak inflation scenario and financial stability concerns. We believe that asynchronicity will continue to be the name of the game, with the Fed slowly normalizing rates, the ECB ready for another wave of unconventional measures and the Bank of Japan recently moving into negative rate territory. This should open up relative value positions among currencies and yield curves. For EM equities, due to the historical high correlation between oil and global demand, lower oil is taken as a proxy of the global cycle, hence as bad news. This is true especially for Korea, Indonesia, Czech Republic and Brazil (Indonesia and Brazil s economy are also very linked to oil). Some exceptions are Hungary, Turkey and Poland, where lower oil could drive a higher upside as oil is mainly a cost variable. Selectivity will continue to be key in the EM area. Here we prefer countries, such as India, that have the space and credibility for adjustment and rebalancing the economy, and that can also enjoy the oil dividend. 4 The lowest potential yield that can be received without the issuer actually defaulting. 8

Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of February 18, 216. The views expressed regarding market and economic trends are those of the author and not necessarily Pioneer Investments, and are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Pioneer Investments product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any services. All investments involve risks. You should consider your financial needs, goals, and risk tolerance before making any investment decisions Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: February 23, 216. Follow us on: www.pioneerinvestments.com 9