Growth at risk
New highs for oil prices, the latest report on the (non-) existence of Saddam Hussein’s weapons of mass destruction, hurricanes, terrorist bombs, and G7 meetings, and the usual slew of economic data that keeps on coming – all in all just another average couple of weeks for world watchers.
Capital markets may be somewhat range-bound, but oil certainly is not. Indeed the European Central Bank has been sounding much more hawkish (particularly in its September bulletin) citing the oil price and second round effects – such as higher prices and higher wage demands linked to higher fuel costs.
However the consensus view today is that the oil price should not cause such anxiety as it did in the past. Indeed the euro/US dollar rally until early in 2004 has largely offset the rise in crude oil prices, and euro strength has also helped to keep interest rates low, further supporting financial asset prices.
It also seems that a much higher oil price is perceived as more of a worry for growth than inflation, according to the latest Euroland purchasing managers’ reports (PMI) which indicated that the uncertainties (in oil prices, for example) are encouraging customers to delay placing orders.
“Increasing oil prices is like a tax on consumers and corporates and acts to reduce consumption,” states Emeric Challier, head of euro fixed income at Fortis Investments. “Some estimates suggest a sustained level of $50 per barrel would cut growth by 75 basis points.”
Heinz Fesser of DWS says: “We are not set to endure another oil shock. Most industrialised countries have developed policies to get alternative sources of energy to meet their needs. And whilst I agree that there has been huge demand for oil, particularly from Asia and now the US after the storms, I do not believe that global demand is going to rise significantly from today’s levels. It seems very likely that speculative activity explains at least some of the price rise.”
Frankfurt-based Fesser argues that the ECB is possibly more concerned about upward pressure on inflation from monetary growth and excess liquidity in the system than a higher oil price. He is sceptical that there are significant upward pressures on prices right now, commenting that although headline inflation might gap up, core inflation remains in check.
“If we look at economic cycles during the upswing, production gaps are closing.” he says. “Once they are closed, there is usually a one- to two-year delay before core inflation pressures are seen to start rising. In Europe we haven’t yet reached the stage of full production, there is still excess capacity there. So I believe it is wrong to suggest that Europe is set for a period of prolonged systematic inflation. But there might well be inflationary pressure in some asset classes which may include real estate markets in some countries.”
Challier says: “There is a huge uncertainty on consumption as the oil price continues to gain. Recent consumption indicators have been very disappointing, and the latest (rising) unemployment figures from France and Germany were certainly a concern and this will not be helping consumer confidence. The probability that the ECB will raise rates over the next three to six months is very low, with rising unemployment, poor corporate pricing power and soft wage increases.
“It is amazing to acknowledge that inflation in the G7 countries is as low as it still is despite the soaring oil price. The deflation forces talked of by the Central Banks in 2003 are still at work now.”
So in the meantime, where does the smart money go? Well not government bonds and not long duration either. Credit markets still hold appeal. “Although spreads are tight, we do not see much reason for them to be much wider,” says Fesser. “We have improving corporate cash flow, a healthier debt situation and no huge need for investment.”
He adds that though it might not be the norm, it is not wholly unprecedented for credit spreads to be shrinking as interest rates rise and cites the case in 1993/94. And Fortis Investments’ Challier makes the additional point that the credit markets are also well supported by some technical factors including strong demand for CDOs.
Although emerging market debt has already been a good performer through 2004, DWS still finds it an interesting asset class. Fesser says: “Fundamentally the situation is good, with rising commodity prices and interest rates still low, even if they are now rising. Outside the emerging market world, five to seven year bonds yield less than 4% – it is possible to get double that in emerging market bonds for similar maturity. That is not cheap but still a considerable investment environment.”