EU Crisis Means Slower Global Growth - Cheaper Oil, Gold Surge to Continue

* Oil has shown the greatest change in prices over the last two weeks, so I am starting off today’s blog with a look at what this means for other asset categories. Oil has fallen in price by 20% from its recent peak. This seems to correlate to problems in the euro-zone, and expectations that EU problems will translate into slower global growth, and lower demand for oil. In fact, if you look at the first chart, it appears that oil has fallen out of the up channel, from a recent high above $87 a barrel. This channel crosses in the very low 70s, so for the time being, I will view prices below 70 as confirmation that this channel is broken. 


What does this dramatic drop in oil portend for other asset classes? For one, there is a fair portion of the stock market which correlates to the fortunes of oil and resource stocks, so there is some direct linkage there. In addition, lower oil prices also ties into lower inflation expectation, and on average, that is bullish for bonds, and implies lower interest rates. In fact, rates are down over the last two weeks, but the interest rate trend actually goes back 6 weeks. In contrast to oil, gold, which usually correlates with oil, is up over 6% in the last 2 weeks, from 1140 to 1210 (this morning).

If you look at oil in terms of the Euro, which has dropped concurrently with oil, you will see that oil’s price has dropped (see the second graph) too, but not as much oil in dollar terms, and it still remains within the up channel. A more bearish chart is that of the CRB index, (see the 3rd graph), which shows that trend is even weaker that the oil chart, in dollars or Euros. Collectively, all three charts warn us that a new deflationary trend could be in the process of taking hold.


This all feeds back to the stock market, which also has been in a down trend over the last 3 weeks. The recent strength of the dollar has been feeding a weaker stock market. With 65% of the S&P 500′s earnings coming from overseas, this has been one of the reasons why traders have been selling stocks. However, a look at the charts shows that the dollar has been in an uptrend since early December, so while this excuse is convenient if only looked at over the last 3 weeks, this does not solve this riddle. The best I can do to tie in the rise of the dollar has to do with interest rates, see next graph. From early December through early April, US rates rose, and on average, higher rates help improve the valuation of the dollar. This is denoted on the graph by the two yellow lines, when this was the trend in force. After the second yellow line, early April, US rates came down as capital flows started moving into the dollar and dollar assets, in a flight from the Euro currency. This points out the fact that cause and effect can reverse itself quick quickly, with a flip in these relationships during the recent trend in dollar strength.

 Gold, ironically fits into none of the trends of any of the asset categories shown previously. With the exception of various periods of correction, Gold has been in an upward trend for the past 10 years. As the next graph shows, the recent rally in gold has been accompanied by a continued rise in Open interest. Is this a result of the record readings of bullish consensus, which in and of itself is bearish? I do not have an answer to that question. What I can tell you is that with open interest continuing to rise, that something has to give. Typically, you would expect to see a drop in open interest as the market continues in the direction of the primary trend, in what is known as a liquidating market. Which suggests to me that regardless of all the other markets, that gold should continue higher. Signs of a drop in open interest as gold makes new highs should foreshadow a shift in gold’s direction. Over the short term, the corrections do not bother me, as such corrections help to relieve over-bought conditions, and tones down the steep uptrend, which is never sustainable. Corrections are the pauses which refresh, so I am optimistic that gold will go through corrections as it moves onto higher prices.


Where do the markets go from here? The main point of this section has been to highlight the leading role which oil is taking in the recent down-trend in recent turmoil. Furthermore, it appears that US rates remain in a bullish trend, which should continue over the next few weeks, consistent with the period of bullish market seasonals.  This could tie into further weakness in oil, as this is collectively consistent with deflation and lower rates, in a self-reinforcing feedback loop. 


* Stocks – I am also looking for a dramatic fall in equity prices over the very short term. This opinion is reinforced by the dramatic drop two weeks ago, as being a harbinger of things to come. Here is my thinking. From the market’s top on April 26th, it took 8 trading days to finish that dramatic move to the downside. From that low, there was a 5 day correction upward into last Wednesday/Thursday. The span of time for the next move shortens to 3 days into yesterday’s low. The market is running out of options, as the time span between sell-offs and rallies continues to shrink. In my opinion, the stock market is nearing a point where the sell-off must resume in earnest, or the upward corrections will continue. This would throw cold water on my view that a sell-off in stocks is imminent. A falling stock market fits in neatly with a resumption of the recent (downward) correction in oil, and falling interest rates, ala the flight the quality (and US assets). Keep an eye on the low 1100s in the S&P, which was yesterday’s low for signs that the sell-off in stocks is resuming in earnest. A high above 1162 would indicate that my idea on stocks is wrong.


What else might drive the next crisis, a flight to US assets, and sinking commodity and stock prices? The last piece of the puzzle might be the UK, and their deteriorating currency, see the last graph on the attachment. I am not an expert on the pound, so I do not have any background as to why the pound bottomed in 1985, but I can tell you that the current weakness in the pound appears to be a continuation of the trend to lower levels from the sell-off during the economic collapse of 2008/2009.  The UK is cited as one of the countries with an over-leveraged housing market, and a government which has been running large budget deficits amidst growing concerns of the sustain-ability of their sovereign debt markets. I could write a whole piece on the UK, but that will have to wait for a future blog. The take-away is that the weakness in the British pound is another marker as to what could drive the next crisis. Keep an eye on the British pound, especially if it goes below $1.40, from its current level of $1.446.

* The EU – over the weekend there was much talk about how the EU was the culmination of decades long aspirations, and at least ten years of work by many, who put the EU together. These articles talked about how various folks spent many years of their lives toward the creation of the EU, and it was not likely that they would let it dissolve that quickly. One of the points of some of these articles centered on the idea, that it was thought to be better to include as many of European countries as possible, in the interests of solidarity, than not. Accordingly, most countries were allowed into the EU, provided they stuck to some general fiscal guidelines. However, the folks who spent a decade conceiving of the EU, did not take into consideration the national imperatives which nations will face in the quest to manage their own economies.  And there is no mechanism to force countries out of the EU, and if a country wants to leave the EU, on what terms can they be allowed to do so. These flaws in the construction of the EU are coming to light as the Greek debt crisis came to the fore. So my question to those who talk about how the EU will not go away so quickly because it is so important to so many, is: 


If the EU is so important, then how did you let this sort of event (Greece) slip through the cracks?


And that is the essence of the bearish case against the Euro. The EU has bought some time, while the weaker EU members will hopefully get their fiscal houses in order, without causing a depression. However, unless they do some work behind the scenes to circumvent the next problem, then there is going to be a real problem in the future.