Energy investors were disappointed with the results of the December OPEC meeting where the cartel decided to maintain production at current record levels rather than rationalizing their individual outputs in an attempt to decrease production and support higher oil prices.  Clearly they still want to put pressure on the ‘higher cost’ non-OPEC producers such as Norway, Britain, the U.S. and Canada.   U.S. shale oil production has surged by over 50% in the past four years to put the U.S. right behind the Saudis and the Russians as the largest global producers.  But if the markets are playing a game of ‘chicken’ with the Saudis, they might be in for a long fight.  Saudi Arabia, the key OPEC player, is basically the lowest cost major producer in the world and can survive low prices longer than anyone else.  Moreover, their internal finances are actually in pretty good shape and would be able to absorb an extended period of low prices.  Saudi debt has dropped from a high of 100% of GDP in 1999 (just after the last major oil price collapse) to only 2% of GDP in 2014 when oil prices peaked at over US$100 per barrel.  Even after the collapse in prices in the past year, Saudi debt is at only 7.8% of GDP, far better than Canada’s level of about 50%, the U.S. at over 80% and Japan at close to 200%!  In the end the Saudis want a greater share of global output so that they can continue to diversify their economy further, maintain generous social programs (free education and health care), subsidize domestic energy usage and support allied countries in the Middle East.  Saudi Arabia won’t be the first major oil producer to ‘blink’ in this stand-off!

While economic growth has been slowing in China, weak in Japan, stagnant in Europe and under severe pressure in the developing world, the U.S. has been the anchor for the last few years, with strong domestic demand and increasing employment levels keeping growth in the world’s largest economy in the 2-3% range for the last few years.  However, between the collapse in the energy sector and the negative impact of the strong U.S. dollar on exports, we have started to see growth slow down south of the border.  GDP grew at only a 0.7% annualized pace in the 4th quarter of 2015.  The weak point is the manufacturing sector, which includes companies that build equipment for the oil and gas industry as well as those that export to global markets.   The chart below shows how this growth went negative in the last two months of 2015, continuing a deteriorating trend.   If U.S. growth is also starting to wane, then the last peg supporting global growth may have been pulled out of the wall.

U.S. Manufacturing Suffering

While we don’t believe the global economy is headed into a recession, growth has clearly been below expectations despite the aggressive actions of central banks across the globe.  The ‘deleveraging’ of debt from the financial crisis continues to weigh on overall growth.  While this means that growth remains below normal recovery trends, it does also suggest that the economic cycle could last longer than normal since we won’t see any of the normal build-ups of inflationary pressures as industrial capacity gets more fully utilized.  Another disappointment on the economic front over the past two years is the fact that the sharp drop in oil and gas prices has not lead to a subsequent jump in consumer spending.  Clearly the implicit ‘tax cut’ of lower gasoline prices is being funneled into debt reduction and investments as opposed to real spending.   Moreover, the growth of importance of the energy industry to the North American economy has also meant that its downturn has been equally hard on the economy.

Fuel, not surprisingly, is also one of the largest input costs for companies in the transportation sector. Therefore, the bear market in crude oil should have given transport stocks a boost relative to other sectors, but that has not happened.  Stocks ranging from Norfolk Southern to FedEx have been weak, which tells us something important and unpleasant about the market and the economy.  The Dow Jones Transportation Average began its decline in March of 2015, and in May became the first major index to suffer a ‘moving-average death cross’, a very bearish technical market indicator.  The bottom line is that the transportation sector is not faring well, which could be a reaction to world events or could be an early warning of pending economic problems.  Add this to the growing list of worries about the market, and, with the index still trading below both of those averages, the ‘bears’ still are in charge.

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