Multiyear period of oil, metal price declines offer glimpse of how falling prices hurt balance sheets
Weak inflation figures across the globe are getting the attention of central bankers, even as rising stock prices and property values, as well as economic growth are becoming the norm across a broad swath of developed countries’ economies.
Yet central bankers haven’t been quite able to begin a return to normalizing their easy-money policies that followed the financial crisis. Delaying those aspirations has been low consumer prices, limited spending on goods and services, and muted wage growth – key data central bankers look at to gauge how near they are to their inflation targets.
Recently the European Central Bank (ECB) delayed talk of when it would wind down its bond-buying program, a policy known as quantitative easing that injects money into an economy via securities purchases, noting that inflation isn’t where it wants it to be or should be. Even as economic growth in the eurozone has remained steady in the 1.8% to 2.0% range since 2015, inflation at 1.3% in June was below the ECB’s 2.0% target.
It’s a similar story in the U.S. Consumer prices were unchanged from May and increased by 1.6% in June on an annualized basis, according to the Bureau of Labor Statistics’ Consumer Price Index (CPI). Core CPI, excluding food and energy prices, was up by 1.7% compared to June 2016. Personal consumption expenditures rose at an annual clip of 1.4% in June, shy of the Federal Reserve’s 2.0% inflation target.
A slight and steady uptick in inflation, in theory, benefits companies through higher pricing power. They’re able to pass on modest price increases and maintain their margins and investors feel confident in buying their stocks. Central banks also have more ammunition to raise short-term interest rates to keep wage and price growth in check and moderate an economy’s expansion.
Price movement is also behavioral, though, and a continuation of falling prices would signal an economy experiencing deflation – which leads to falling consumer demand and economic investment. With the expectation of falling prices, consumers stay on the sidelines and delay major purchases. Companies generally look to cut costs and capital spending.
Debt and Deflation
Debt deflation occurs when asset prices fall but the real value of debt increases because the price of debt was fixed at the time of the loan. If debt deflation becomes acute, it affects banks’ balance sheets because more borrowers default even as the value of the collateral backing the loans declines. It also impacts businesses since the value of assets depreciates faster than their fixed debt payments. Businesses and households also have to cut back on spending to keep pace with their debt payments.
Given the basic dynamics of how deflation makes debt more expensive, highly-leveraged companies suffer when pricing power declines. Falling prices reduce margins and restrict cash flow.
Take the commodities sectors, for example. After reaching record highs in mid-2008, oil prices reached their lows in January 2016, falling by more than 80%. Meanwhile a key commodity index compiled by the International Monetary Fund that includes copper, aluminum and iron ore prices, among other metals, fell by nearly 60% during a five-year period ending in January 2016.
Falling prices like these contributed to a 12.6% default rate on debt issued by commodity companies in 2016, according to Moody’s Investors Service. Of the 144 defaults last year, 66 were in the oil & gas sector, while another 16 were in metals & mining, according to Moody’s.
A rebound in prices is one way that companies can, again, shore up their balance sheets. Moody’s, for example, expects better prospects ahead and forecasts a 3.4% default rate for 2017. That’s thanks, in part, to the rebound in oil prices, which has lifted investor sentiment and improved access to the capital markets for those stronger issuers that survived the recent turmoil.
Stock prices, however, haven’t recovered. One-year annual returns for the S&P 500 Energy Index through July 25 were down by 1.01%. Stock performance for small- and mid-sized energy firms fared worse. The S&P SmallCap 600 Energy Index’s one-year annual returns declined by 13.77%, while annual returns for the S&P MidCap 400 Energy Index fell by 13.18%.
Securities offered through World Equity Group, Inc. Member FINRA/SIPC. Advisory Service offered through BCJ Capital Management. World Equity Group, Inc. and BCJ Capital Management are independently owned and operated. BCJ Capital Management is a (SEC) registered investment adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. BCJ FG 17-532