August 14, 2017 Weekly News
LOCKED AND LOADED
South Koreans have begun preparing for emergency precautions as the animosity between the United States and North Korea continued to escalate throughout the week. Plans released by North Korean state media to launch four missiles within 25 miles of Guam’s coastline were met with inflammatory comments by U.S President Donald Trump, including “military solutions are now fully in place, locked and loaded, should North Korea act unwisely”. Referring to North Korean leader Kim Jong Un, Trump added, “If he utters one threat… or if he does anything with respect to Guam or any place that’s an American territory or an American ally, he will truly regret it, and he will regret it fast”. Guam is U.S territory, a small island about 2,200 miles southeast of North Korea. It is a strategic hub for the U.S. military and is home to over 160,000 residents.
China’s president Xi Jinping has urged all sides to avoid words or actions that could escalate tensions. He believes there needs to be a peaceful resolution to the current nuclear issue. Meanwhile, Russian Foreign Minister Sergei Lavrov urged both North Korea and the U.S to sign up to a joint Russian-Chinese plan that would entail the freezing of North Korean missile tests and the implementation of a moratorium of large-scale military exercises for the United States and South Korea. This plan has not been embraced by either Washington or Pyongyang.
CRUDE OIL STILL RANGE BOUND
Crude oil prices have had significant troubles in breaking past the $50 mark of resistance that has materialized over the past year. WTIC’s 52 week price range has traded between the range of 42.27 and 58.36 as the outlook for crude oil seems to be fading.
Courtesy of Bloomberg.
On the demand side, concerns have surfaced over the world economy’s desire for oil, specifically in OECD countries. Dozens of nations, including France and the UK have shown interest in tapering the sales of diesel and gasoline powered cars by 2040 and 2050. While this doesn’t create any concern over the short term, it is an indication of a paradigm shift in the market’s thirst for crude. Cheaper clean energy solutions and an overall shift in industry trends including expected growth in the electric car fleet from 6 million to 100 million cars are expected to depress oil demand growth in OECD nations. Interestingly enough, the dramatically increased efficiency of gasoline vehicles over the next two decades will have a much greater impact on oil demand than the adoption of completely electric cars will have. The average passenger vehicle is expected to travel 50 miles per gallon of gasoline by 2035, meaning gasoline fueled vehicles will become almost 70% more efficient over the next two decades.
On the supply side, last week’s OPEC numbers showed mediocre cooperation from the cartel’s producers in carrying through on supply cuts. In order for oil price momentum to turn to the upside, production cut compliance will be crucial and will need to increase from the July figures of 75%.
As Mohamed A. El-Erian outlines in his Bloomberg View article “OPEC’s Game Theory Dilemma”, in order for oil prices to be propped up in the long term, OPEC will need to somehow increase its power over the market, either by sending prices to the floor and ramping up production, or by organizing a worldwide cartel, coordinating with non-OPEC producers including the US. Neither of these options seems likely or possible for OPEC, as a price war would become extremely costly, and cooperating with non-OPEC suppliers would be astronomically difficult.
To add to oil’s pricing woes, producers have taken significantly more reliance on hedging to ensure their profitability in the short to medium term. While this isn’t necessarily terrible for oil producers as it allows them to produce profitably in a depressed market, it has had negative consequences on the price of a barrel of crude, as producers use futures to short production at prices above $50.
This creates significant price resistance at the $50 level, but also allows production to continue in the short term at prices lower than that, painting a worse picture for the price of oil.
Consequently, unless the market experiences some kind of price shock, or developing countries take on more of the demand burden, oil prices are expected to stay range bound for a while with a continuing bias towards the downside.
HOUSING MARKET IN CANADA
In July, the Bank of Canada announced an increase of its key interest rate from 0.50% to 0.75%. This is the first rate increase since 2010. The five big banks of Canada have promptly increased their prime lending rates from 2.70% to 2.95%. Housing market fears have risen, and enthusiasm for Canadian banking stocks has decreased.
Courtesy of Bloomberg. See above: A significant drop in the price of CIBC (CM) stock following the interest rate increase.
The effect on the banks stems from the fact that a significant portion of their earnings is derived from residential mortgages. Realtors have had mixed feelings about the housing market. According to Brian Torry, general manager at Bosley Real Estate in Toronto, nearly half of Toronto's licensed realtors did fewer than two deals last year and less than a third did five or more transactions. According to Philip Soper, CEO and president of realtor Royal LePage, the impact of higher mortgage rates will be minimal, despite the fact that some customers may be dissuaded from buying. “It does raise the cost of a home, because most people buy homes on carrying cost, not on sticker price,” said Soper. “But it’s very minor and it’s been priced into banks’ risk models for several years now.”
Investors have been turning to insurance companies to benefit from the increase in interest rates. Higher bond yields reduce the value of insurance companies’ liabilities, boosting their earnings. Although interest rate increases usually benefit the net margins of Canadian banks, the changes in the housing market have led to uncertainty in the banking sector.