Oil and China: Pockets of Opportunity?



2016 opened with volatility we haven't felt in several years. Much of investors' fear has been anchored to concerns about persistently falling oil prices and a deterioration of the Chinese economy. Our view is that this fear may be due to a misunderstanding of several fundamental economic dynamics. Thus, we believe that while recent volatility is not going to go away anytime soon, it will also create opportunities for an investor who is both prudent and patient.

Oil prices have been falling since the middle of 2014. Why? Two of the oldest forces in economics: supply and demand.  Recent supply growth has been largely due to the revolution of U.S. shale production; it has doubled over the last 5 years, and this in large part is due to technological advances like fracking. Other major oil exporters, most notably Saudi Arabia and Russia, have been refusing to cut output - even in the face of falling oil prices. They've been engaged in an increasingly painful game of chicken. Compounding this problem, on the other side, has been a slowdown in the growth of demand. This is rooted in China's lower need for oil as it scales back its infrastructure initiatives. So, what is the result of this? We have roughly 2% more supply than demand in the market. While historically this is a high number, we don’t think it’s an imbalance that will last for most of 2016. For virtually all oil producing nations these prices are simply unsustainable - they are losing money on every barrel they sell (or, really, store). We believe that either an agreement for coordinated supply cuts will be reached by the major players or one of the smaller nations will cease production – sacrificing itself, but benefiting the other producers. Regardless, the resulting reduction in supply and continued growth in demand would cause the imbalance to correct itself rather quickly creating a significant upward pressure for oil prices.

We mentioned that China's reduction in infrastructure spending has been a key reason for the slowdown in oil demand, but why? What is China's reason for building less? We don’t think it’s an ailing economy. China is in the middle of a government-orchestrated metamorphosis from an emerging to a developed economy. At the heart of this transformation is a shift in focus from manufacturing and exports to services and internal consumption. Viewing China as merely an enormous exporter of consumer goods is looking backward. China’s future is in the services sector. We believe such a tectonic shift cannot happen without rattling the markets. Adding to this volatility is the Chinese government; it has immense power, but little experience with finding the right balance between regulation and outright control of their financial markets. This is something that is necessary for a successful open economy that the Chinese government is trying to create.

It’s not necessary to invest directly in China to feel its effects. China's economy has an impact on other emerging market nations, its regional neighbors, commodity exporters, and most multinational corporations in the west, from automakers to fashion houses.

Last year we reduced exposure to China and other emerging markets as they appeared overheated. After the recent correction, however, we are beginning to see pockets of opportunity. Nevertheless, we remain cautious and emphasize the need for a skilled active manager; one who can separate the wheat from the chaff.

In today’s connected world one jigsaw piece can fit many puzzles.



This video is provided by Pacific Funds. These views represent the opinions of Pacific Life Fund Advisors, not Pacific Funds, and are presented for informational purposes only. These views should not be construed as investment advice, the offer or sale of any investment, or to predict performance of any investment. The opinions expressed herein are based on current market conditions, are as of February 16, 2016, and are subject to change without notice.

Pacific Life Fund Advisors LLC (PLFA), a wholly owned subsidiary of Pacific Life Insurance Company, is the investment adviser to the Pacific Funds. PLFA also does business under the name Pacific Asset Management and manages certain funds under that name. Pacific Funds refers to Pacific Funds Series Trust.

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