The rapid oil price drop has created negative ripple effects that are beginning to spread across the U.S. economy and world.
Trying to quantify all the negative effects of the oil price drop before they happen is virtually impossible to do. It would require a super-computer simulation on an order of complexity that is beyond most of our grasps. I'm sure the Federal Reserve has access to such a computer model but most traders do not. However, there are some educated guesses we can make based on historical data and trends currently developing.
Oil Price Drop Impact on Economy: Pushes State Budgets in the Red
About 40 states derive a large percentage of their income from energy related business. Here are the top 10 states with the most income coming from the energy sector:
1. North Dakota
5. New Mexico
In oil dependent States, coffers are dwindling at an alarming rate. With huge holes blown into State budgets, State's will have to cut public services in 2015. For example, Alaska is a whopping -$3.5 billion in the red because of the oil price drop. Alaska will likely be making cuts to public schools.
Oil Price Drop Impact on Economy: In Small Counties Across the Oil-Belt, Oil Price Drop Raises the Risk of Bankruptcy
We could see a wave of bankruptcies from small counties across the oil-belt. For example, a whopping 50 percent of the jobs in Uintah County, Utah, could be lost from the crash in the price of oil.
Oil Price Drop Impact on Economy: Cities Across the Oil-Belt, the Risk of Default on Municipal Bonds Is Higher
I don't want to pull a Meridith Whitney here but the risk of default by cities on municipal bonds has gone up across America. The oil price drop is negative for some municipal issuers because of a potential decline in employment and revenues. Bondholders can be negatively impacted because shrinking revenue leaves less money to meet debt payments.
Many cities are still trying to recover from the Great Recession. The oil price drop could be the final straw that pushes these cities into default and bankruptcy.
Oil Price Drop Impact on Economy: Sovereign Wealth Funds, Oil Price Drop is a Margin Call As They Sell Everything To Meet Margin Requirements
Sovereign wealth funds hold more than $5 trillion in assets. A stunning 6 out of the 10 largest sovereign wealth funds in the world are oil based funds. Energy exporting countries hurt from the oil price drop are being forced to draw down their sovereign wealth funds. This has created selling pressure in stock, bond, and property markets worldwide.
Oil Price Drop Impact on Economy In Small Countries
In many parts of the world, oil is the only source of income that a country has. The drop in the price of oil will create more instability as people take to the streets.
Oil Price Drop Impact on the Euro Zone
The oil crash has caused runaway deflation across the euro zone. If Greek elections bring in a new government that wants concessions from euro zone members, Germany wants Greece out of the euro zone. The threat of deflation has gotten so scary that Germany has its own problems to deal with and won't entertain Greek drama.
Oil Price Drop Impact on Russian Economy
Russia appealed for calm among its citizens last week as the crash in the price of oil forced it to make big cuts to its budget. Russia has vast gold reserves. Russia is not selling its gold. Instead, it's dumping its U.S. Treasury bonds.
The drop in the price of oil has forced Russia to raise rates to hold up the Russian ruble. Inflation could hit an annual rate of 17% by spring.
Oil Price Drop Impact on Economy: CPI
The CPI report showed that consumer price inflation went negative in December, falling -0.4%. This is a signal that more disinflation has hit the U.S. economy. Negative inflation, or disinflation, is the opposite of what the Federal Reserve has been trying to do for years. The Fed wants inflation at +2%. Inflation is moving in exactly the opposite direction.
Below is an excerpt from the weekly Saturday show that airs on YouTube where I discuss the ripple effects caused by the oil price drop.
Fears of disinflation becoming a vicious deflationary cycle spread across Wall Street today. Deflation news spread fear and volatility across markets.
At market open, SPY did a gap up open and then ripped higher. Just after 10:00 AM on January 13, 2015, SPY was up +1.4% from the previous day's close. Just 10 minutes later, SPY started selling off. It fell -2.4% by 2:20 PM.
The popping energy bubble has ignited fears that we are in a disinflation plunge that is quickly becoming a deflationary environment.
Deflation News Catalyst is the Rising U.S. Dollar
Peter Schiff agrees with me that the rising U.S. dollar, because the Fed ended QE, is helping cause the price of oil to crash, and is putting a downward pressure on stocks.
Deflation News Ripples Through Economy and CRB Index
The -0.2 plunge in average hourly earnings from the January 9, 2015 Employment Situation Report really unnerved a lot of traders. But what is really freaking everybody out is the CRB index. The CRB index has predicted every inflationary/deflationary cycle since 1967.
Most traders know that the Federal Reserve has been battling disinflation since 2011. The Fed has repeatedly pumped money into the economy since 2011 in order to prevent the economy from going into a deflationary spiral. With the energy bubble popping, the CRB index has plunged in a way only seen during the onset of major Bear markets.
CNBC had Steve Massocca from Wedbush Equity Management on today. Check out what Mr. Massocca had to say when asked if the drop in the price of oil justified today's sell-off.
Steve Massocca mentioned the drop in the price of copper. Traders watch copper as a kind of barometer on the health of the global economy. The reason copper is such a bellwether indicator is that it is used in so many different industries and products.
The popping of the energy bubble and the fear of deflation is clearly scaring traders.
Deflation News and Central Banks
It's possible that we could see the Fed not only NOT raise rates, but maybe even start up another round of QE if deflation begins overwhelming markets.
There are multiple deflation news hot spots you should be tracking right now. They are: rising U.S. dollar, energy bubble popping (includes falling price of oil, oil rigs closing, energy sector layoffs, energy sector bankruptcies, and global margin debt that was financed by oil), falling CRB index, falling price of copper, falling wages, and Central Bank action from our biggest trading partners and if they are devaluing their currencies.
The energy bubble popping was the worst possible thing that could have happened in terms of helping the Fed fight disinflation.
The longer that we allow Japan and Europe to devalue their currencies, without devaluing our own, the more deflation we absorb from those countries. Remember, the rising U.S. dollar is deflationary. A falling U.S. dollar is inflationary. The Fed prints money and devalues the dollar to create inflation (like Japan is doing right now). The Fed raises rates to create disinflation and soak up excess U.S. dollars. As the dollar rises in value, all good and services, and even the stock market, goes down (i.e. it takes fewer dollars to buy the same amount of goods).
Like most traders, you probably have never heard of the Employment Cost Index. There's a good reason for that. This is not an economic indicator that usually moves markets. Here's why that has changed.
The Employment Situation Report released on January 9, 2015, showed a plunge in average hourly earnings. The consensus for the month over month change was 0% to 0.3%. The actual number was a surprising -0.2%.
Higher wage jobs are being lost across the entire energy sector. The price of oil and the energy sector is the heart of the economic circulatory system. Why did hourly earnings plunge last month? Probably because of the energy bubble popping but we need more data to know for sure. Enter stage right: Employment Cost Index.
What is the Employment Cost Index?
The Employment Cost Index is a measure of total employee compensation costs, including wages and salaries as well as benefits. The Employment Cost Index (ECI) is the broadest measure of labor costs.
The Employment Cost Index (ECI) is a way to analyze wage trends and the risk of wage inflation or deflation. Wage inflation happens when economic activity is booming and the demand for labor is rising rapidly. Wage disinflation happens when economic activity is falling and the demand for labor is dropping rapidly. During economic downturns, wage pressures tend to be subdued because labor demand is down.
By tracking the Employment Cost Index (ECI), traders can gain a sense of whether businesses will feel the need to raise prices. If wage inflation occurs, it's a good bet that the Fed will raise interest rates. If wage disinflation occurs, then I think the Fed puts off raising interest rates for fear of putting the economy into a deflationary death-spiral.
The ECI is published quarterly. The 2015 release schedule for the ECI is: 1/30, 4/30, 7/31, and 10/30.
Will the Employment Cost Index Confirm Wages Are Dropping?
Lower oil prices are starting to show up in non-oil price items like core inflation. The drop in hourly earnings is a sign of disinflation. Remember, in a deflationary environment, employers are more reluctant to give out raises.
Traders will focus on the January 30, 2015 release of the Employment Cost Index (ECI) to see if that confirms the decline in wages from December's Employment Situation report. The ECI will tell us if we should worry about declining wages across the broader economy.
Margin debt is the gateway through which the rapid drop in the price of oil can crash the stock market.
Margin debt fuels stock purchases. For years, margin debt has been rising. Today it sits at sky high levels never seen before.
We saw sovereign wealth funds order institutional traders to sell some of their equities after OPEC decided to not cut production in November 2014. That's one form of a margin call. But rather than just being a margin call on a few traders, it's a global margin call that impacts markets around the world.
If you trade on margin, then you know that when you buy certain stocks, your online broker will extend you margin buying power. If it's a risky small cap, you won't be extended any margin when you buy a stock. Early last year, if you bought a big blue chip oil company, you were extended 50% margin. So, if you bought $10,000 worth of stock in a big oil company, your margin balance was increased by $5,000. That's another $5,000 you can use to buy even more stocks. Depending on your total account balance, you are charged anywhere between 3% and 8% interest when you buy on margin. If you make anything above that interest rate in a year's time, you get to keep the profits. It's almost like free money to invest with, until the market goes down.
When the price of oil crashed, the margin rate on many stocks dropped. No longer would your brokerage firm extend you 50% margin on certain big oil companies. But it gets worse. If you already borrowed money on margin, and your brokerage firm reduced the margin level of a stock you hold, a margin call went out and you were forced to either put more money into your brokerage account or sell some of the stock you bought with that borrowed money to reduce your margin level.
Folks, reduced margin is where I think the crash in the price of oil has the biggest potential to crash the stock market.
Margin Debt Chart
As you can see, every big stock market crash over the last 15+ years was led by a plunge in the margin debt level.
Margin Debt Versus Price of Oil Chart
Notice that when the price of oil began to crash in August of 2014, margin debt began rolling over as well. Notice that none of this is yet reflected in the S&P 500 because margin debt is still being used at very high levels. However, if margin debt levels keep falling, they will impact the S&P 500 as history has shown.
Below is an excerpt from the January 3, 2015 show where I discuss margin debt and the drop in the price of oil: