Oil is adding to its decline today causing shares of energy companies to follow suit. Extra stress is placed on Russian shares which has been taking hits from the drop in oil, among other factors such as sanctions. In dollar terms the drop is even worse. With the Rouble declining from 58 to nearly 66 as of now, the economy of the country is in dire need of changes. The government of Russia will have to start to take accountability for the sanction that have been placed on the country and move towards reforming the economy. Even with that there is still the countries dependency on oil for its revenues. This is causing a majority of the declines we are seeing on a daily basis with oil's drop.

Russia seems to be a leveraged play on oil in the near term with the added risk of geopolitical tensions. Should the sanction be lifted the currency could start to stabilize and over time more investment from the cheap loans the ECB is offering could be placed in the country.

Markets are down over 1.5% today  with oil once again leading the decline. Many of the headlines say markets are down on oil dropping. On the face of it that doesn't seem to make sense. A decline of oil is supposed to be a boon for the economy and stimulate growth and by extension equities. What is happening in the markets now is the start of a shift in bias in why oil is dropping, Since the middle of the year much of the decline in oil has been attributed to oversupply, and I believe that is the case, but recently with more news coming out over Chinese trade doing poorly the market is starting to think that the continued decline is the demand side of the equation taking over.

While this will cause more correlation in the markets should the trend continue to be confirmed, then the market will have plenty of hiccups ahead as the oil market tries to re-balance itself to the growing supply/demand imbalance. Companies such as ConocoPhillips which I have recently wrote about, has announced a 20% reduction in expenditures in the next year and more companies will be following suit, it they already haven't. If oil keeps declining in the face of these pullbacks in supply generation, we will most likely see more selling in the equity markets and flights to safe haven assets as more market participants will see the issue then stemming from the demand side of the equation.

The first of 2 parts on energy in the real assets series.


Investing in Real Assets: Energy (part 1)

Looking at the coming week there are several key drivers that could change market sentiment, or reinforce it. On Thursday the ECB will announce the participation in the LTRO and China will reveal inflation and industrial production Wednesday and Friday respectively.

In terms of the LTRO, a lack of participation will confirm more action will be taken in terms of outright bond purchases. One of the goals of the ECB is to grow the balance sheet by €1tln which will difficult without bond buying. Limiting the amount of bond buying to €500bln will not be enough to make dents in the market at the current state, but any increases in the buying will no doubt be met with pushback  from Germany. Look for a poor turnout in the LTRO to add more uncertainty to the overall euro zone  situation.

China's numbers will no doubt bring  about volatility in the energy market as well as the Chinese equity markets, which have been hot as of late. Poor reading in inflation could provide wiggle room for more stimulative measures but a poor manufacturing number will no doubt cast a shadow over markets globally.

Deflation is a big concern in Europe at the time. With Draghi, head of the ECB, waiting to take action on the slowing growth numbers in the region push prices closer to zero. Many of us know the main causes of deflation such as large drops in demand due to recessions or austerity (Europe) or from a decline in spending and lending. But another interesting notions is that of growth deflation.

Growth deflation is something that stems from technological advances and increased efficiencies having supply outstrip demand. Add to this a dose of competition and price declines are bound to happen. We have seen new firms come in over the past several decades and create technologies that allow us to do everything from online banking and shopping to accessing vast amounts of natural resources in areas once thought impossible. This has happened in America in the past with much of the last half of the 1850's in mild deflation (with the exception of the civil war). After the FED was created and took on broader roles in the 1960's the US has not seen significant deflation occur. Despite crises and technological advancements.

If this is due to the FED working to keep deflation out of the economy despite the advances in technology, increases in innovation, and prices dropping drastically on goods due to competition; the government has absorbed much of the price declines through more debt and the Fed expanding its balance sheet. Now the debt is at record levels and the balance sheet has increased 3 fold since the start of the crisis, it seems the most extreme measures have been taken to avoid deflation. Which is good given the amounts of debt now in the global economy. But what if the measures that have been so accommodative to more money and debt not spurring large spikes in inflation stop to produce? If growth deflation stops or slows inflation moving up in a sharper than expected fashion could spur a lot of the money already outstanding to come out of savings and start to increase velocity in a fight for real assets.

In short what if the longer term fight against deflation has sown the seeds for uncontrollable inflation to take root.