Sunday, 7 February 2016

Oil and Equities

At the end of 2014, and start of 2015, I set out, in a series of posts, the causes of the slump in oil prices, and the prices of other primary products, and the effects these price falls would have on the global economy, and on financial markets. Despite all of the media punditry claiming that these price falls are the consequence of slowing global growth causing a fall in demand, the fact is that the global demand for and consumption of oil has continued to rise by around 2% a year. The same is true for most other primary products such as copper. Even where demand for some of these primary products has now fallen, the reduction in demand is slight compared to the fall in price. The price falls are not the result of falling demand, but of massively increased supply, as past investment, spurred by the high prices generated after 1999, led to overproduction.

In those posts, I described the way the fall in oil prices would be good for the global economy, but very bad for financial markets. Again, if you listened to the various financial and media pundits, such a dichotomy would seem incomprehensible, because they make no distinction between the two. As John Weeks, wrote recently,

“The pervasive control of the UK economy reveals itself in what passes as economic news, more correctly named “speculation news”. Since the beginning of 2016 the media’s reporting of the movement in stock markets has reached the point of obsession. Each day’s business news headlines focus on whether these market indices fall or rise. Commentators present a fall as a harbinger of disaster, with a rise provoking optimistic cheers that we escaped disaster.” 

And yet, as I have described previously, there is an inverse relation between economic growth and financial markets. In the periods of long economic upswing, financial markets and financial assets tend to rise more slowly, whilst during the long periods of slower economic growth, financial markets rise more rapidly. Between 1950 and 1980, US GDP rose by 850%, whilst the Dow Jones Index rose by 312%. But, between 1980 and 2000, the US economy grew by just 260% whilst the Dow Jones rose by an astronomical 1300%! A similar rise could be seen for the S&P 500 Index, and for the stock market indices of other countries. 

The reason there is this inverse relation is quite simple. Typically, during periods of long wave boom, available money-capital, realised from a growing mass of profit, gets invested in real productive-capital, causing the economy to grow faster. Although, as Marx described in relation to the long wave boom that began around 1843, this mass of profit may be so great that it can't all be invested productively, immediately, and so leads to money-capital pressing down on interest rates, and fuelling speculation, these bubbles burst, allowing the economic growth to continue. As this economic growth continues, the demand for money-capital begins to outstrip the supply – which may be due to the demand rising more quickly, or the supply falling, or a combination of the two.

In either case, during such periods, typically a greater proportion of realised profits will go into productive investment. As the demand for this money-capital begins to outstrip the supply, the average rate of interest begins to rise, and this causes the prices of fictitious capital to fall, as a consequence of the process of capitalisation. That consequence is even more apparent during the Autumn phase of the long wave cycle. During the earlier part of that phase, in particular, rising wages, as labour supplies become tight, and productivity falls, cause profits to get squeezed. 

As Marx describes in Capital III, examining the relation of the interest rate cycle to the economic cycle, interest rates during this period reach their peak, because businesses demand money-capital now not to invest in additional capacity, but simply to be able to stay afloat, to pay their bills. As Marx describes, the lenders of money-capital are not at all concerned that those who borrow their money-capital do so to actually use it as capital. It is all the same to them, whether it is used productively or to finance a lavish lifestyle, or simply for a business to pay its bills. For the owner of the money-capital, they seek to obtain its market price, the average rate of interest, whatever the borrower's requirement might be.

And, that can be seen today. A country like Saudi Arabia, for the last thirty years and more has been a huge supplier of money-capital into the global money markets. It was able to do so, because high oil prices provided it with rent from surplus profits. Very little of Saudi's oil revenues went into productive investment. A large part went into keeping its population pacified, and the rest went into financial speculation, helping to boost the stock markets in London and New York, as well as making available the money-capital to buy up their government bonds, and provide money-capital to increase the growing mass of credit that kept the mass of household debt in the UK and US soaring.

Saudi and the other Gulf oil producers were not alone. Other oil states, like Norway, had huge excesses of revenues from oil rents, which they pumped into the development of sovereign wealth funds that bought up the existing stock of shares and bonds in global financial markets, pushing their prices ever higher. As the prices of other primary products soared after 1999, when the new long wave boom massively increased the demand for those products, countries supplying those products also found themselves with loanable money-capital available to speculate in global financial markets. One of the most visible, in that regard has been the influx of Russian oligarch's into London. And finally, of course, there was China whose vast treasure chest of loanable money-capital came not from such rents, but from its ever increasing volume of exports.

Over the last few weeks, there has been an almost perfect correlation between oil prices, and stock markets. Whenever, oil prices have fallen, stock markets have dropped, and vice versa. One reason for that is that in the US and UK, the stock markets are heavily weighted in favour of oil companies. The UK FTSE is dominated by large oil and mining companies. The Dow Jones is also heavily influenced by the US oil giants, and with the growth of US oil production due to shale, the sharp drop in oil prices has badly affected those producers, as well as the suppliers of capital equipment to them. It also means that a very large amount of junk bonds, used to finance those shale producers, are now in danger of default, which could have a cascading effect through debt markets. In fact, there were some suggestions last week that even some of the large oil companies could now be facing problems covering the interest payments on their debt. At the same time, some of those companies have insisted that they will keep paying out the same level of dividends to shareholders, even if they have to borrow money to do so!

The falls in stock markets are then both a consequence of the direct effect on oil companies, which have a large weighting in some of these stock markets, but also of the fact that what were once providers of huge sums of loanable money-capital, have overnight become borrowers. That has the effect of pushing up global interest rates, which then, via the process of capitalisation, causes the prices of these financial assets to drop.

At the same time, the beneficial effects from the drop in oil and other primary product prices are not so immediately apparent. The fall in these prices acts to both release capital, and to raise the rate of profit.

“Other conditions being equal, the rate of profit, therefore, falls and rises inversely to the price of raw material. This shows, among other things, how important the low price of raw material is for industrial countries, even if fluctuations in the price of raw materials are not accompanied by variations in the sales sphere of the product, and thus quite aside from the relation of demand to supply.”

(Capital III, Chapter 6) 

When the drop in oil prices began in 2014, that coincided with the onset of the three year cyclical slowdown, which began at the end of 2014, and ran through to the end of 2015, which thereby disguised some of the effect of the oil price falls, but also, with huge amounts of household debt, it is not surprising, as I suggested more than a year ago, that consumers would use some of the reduction in their necessary spending to reduce those debts. In the longer term, that is still beneficial, because as consumers reduce their debt, they also reduce their future debt servicing costs, which leaves them income available for actually buying commodities. As Marx says above, however, even without this effect in increasing demand, the lower cost of raw materials for the vast majority of businesses, leads to a rise in the average rate of profit.

But, as I suggested, nearly three years ago, the conjunctural changes we are seeing in the global economy currently, have other consequences. For the last four years, the US economy has been creating nearly twice as many new jobs as are required to absorb the increase in its working population. That has caused its unemployment rate now to fall below 5%. One of the consequences of this has been mentioned above, which is that as supplies of labour-power get used up, wages are pushed higher, and profits are squeezed, and that is exacerbated as productivity growth is slowed.

“Given the necessary means of production, i.e. , a sufficient accumulation of capital, the creation of surplus-value is only limited by the labouring population if the rate of surplus-value, i.e. , the intensity of exploitation, is given; and no other limit but the intensity of exploitation if the labouring population is given.”

(Capital III, Chapter 15)

The consequence of these structural changes is that as wages rise, as a proportion of national income – both because more workers are employed, and because wages rise – this leads to a corresponding change in the structure of the national product itself, as demand for wage goods rises.

“If the surplus wages were spent upon articles formerly not entering into the consumption of the working men, the real increase of their purchasing power would need no proof. Being, however, only derived from an advance of wages, that increase of their purchasing power must exactly correspond to the decrease of the purchasing power of the capitalists. The aggregate demand for commodities would, therefore, not increase, but the constituent parts of that demand would change. The increasing demand on the one side would be counterbalanced by the decreasing demand on the other side.”

(Value, Price and Profit, Chapter 2)

Although its true that a general sharp increase in the rate of profit may lead to a rise in capital investment, and vice versa, there is no mechanical relation between the two. For one thing profits may rise too quickly to be immediately accumulated in productive capital. Especially, as the minimum efficient technical size of investments continually rises, that becomes more so the case. In fact, its far more likely that any increase in profits after a period of large scale fixed capital investment, will take the form not of further investment in fixed capital, but in additional circulating capital, i.e. additional materials, and labour-power to process it, because as Marx says, capital becomes very elastic in its ability to expand output without such additional investment in fixed capital. A look at the continued expansion of employment over the last few years, indicates precisely such an accumulation of circulating capital rather than fixed capital.

But, similarly, a fall in the rate of profit may not at all be a cause for a reduction in investment. For one thing, firms may invest to try to boost their profits either by improving their competitiveness, or simply in the hope of capturing a larger market share. That is particularly the case where demand may be rising. In discussing the theory of rent, Marx criticised Ricardo for the view that it is only when prices, and profits are rising that a cause for additional investment is provided. Marx points out that as population grows this leads automatically to a rise in demand, and so it is natural for additional capital to be accumulated to increase supply so as to meet it. Indeed, a general precept of every business is that it will need to continually increase its supply so as to meet the requirements of a growing market.

In conditions where employment and wages are growing – US hourly wages grew by 0.5% last month – this means an expansion of demand for wage goods, which individual capitals will have an incentive to meet. In the US, that may be particularly marked, because a large part of the rise in hourly wages appears due to the rise in the minimum wage. That means lower paid workers have more to spend, and the marginal propensity to consume increases at these lower income levels. But, last week has also seen proposals for new taxes on oil to pay for much needed spending on repairing and renewing US infrastructure. Whether these taxes are implemented or not, the fact remains that the US does need to spend money on its infrastructure, if US capital is to have an adequate framework within which to operate efficiently. Moreover, its not alone. Similar expenditure is required across Europe. The consequence is that increasing amounts of money-capital are required to cover such investment, and spending.

Once again, this means that the demand for money-capital rises relative to the supply, pushing interest rates higher, with a consequent depressing effect on capitalised asset prices. The financial and media pundits continue to talk about the current market sell-offs being a harbinger of recession ahead. In large part that is them talking their own book, attempting to convince central banks to keep providing the money drugs, in the hope of preventing bubbles from bursting. But, it also reflects the misunderstanding referred to above, which equates speculation with investment. As US economist Paul Samuelson, once wrote, “The US stock market has predicted nine of the last five US recessions!”

CNBC's, Steve Liesman, last week examined the record, and found that indeed that relation between bear markets and subsequent recessions was about right. Of course, as Marx explains there is no reason why a purely financial crisis should affect the real economy. It can, in fact, be beneficial. Its only if such a financial panic causes a general dislocation, as happened in 1847, and 2008, for example, that it need impact the real economy. In reality, it has been the role of central banks in continually pumping liquidity into markets to stop the collapse of asset price bubbles, and subsequently to reflate them, which has been a major drag on recoveries, because it has meant that money-capital has continued to flow into those financial assets, in search of guaranteed, fast and significant capital gains, rather than into productive investment.

But, in the end, as Marx describes, the economic laws will impose themselves. A lack of productive investment, as resources are diverted to speculation will simply lead to yields on financial assets getting smaller and smaller. We now have the ridiculous situation of negative interest rates, for example. The replacement of yield with speculative capital gain can also only go on for so long. In the UK, most clearly, the majority now cannot afford to buy a house, and many of those with houses cannot afford to move up to a better one. The majority of mortgages are going to Buy To Let Landlords, whose rental yields are also getting squeezed, as the prices they have to pay for properties gets pushed higher, as they compete against each other, whilst tenants are unable to pay higher rents, especially as Housing Benefit is restricted or withdrawn.
There comes a point at which buying a property nominally to rent, but really in the expectation of making a capital gain, is not a wise bet, because at some point, there are no bigger fools around to bid those prices higher, and at those points the prices tend to simply collapse. But, the same applies to stock and bond markets. The reality today, as it has been for the last two or three years, is that the real threat to financial markets comes not from a recession, but from stronger economic growth, as it pushes wages higher, squeezes profits, leads to an increased demand for capital, and pushes interest rates higher.

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