On August 20, NYMEX crude oil futures reached $49.40/bbl (e40.2), a level that, in inflation-adjusted terms, has previously triggered recessions and sharp declines in stock market prices. Oil prices have corrected since, but they will probably remain at their current high levels and could easily jump higher. This being the case, will the situation be different this time?
In inflation-adjusted terms, the August 20 price level is more or less equal to that reached after the 1973 oil shock, but still 84% below the peak of October 1981 ($90.8). High oil prices are due more to high demand than to geopolitical risks. Demand from emerging countries has risen steadily in recent years. Between 1980 and 2002, petroleum consumption in China rose by 192% and in India by 240%.
Due to a lack of profitability over the last two decades, oil majors have not invested sufficiently in exploration and developments of new oil fields. Fewer than 2,500 rigs are drilling for new oil and gas around the world, less than half the number during the peak in 1981. Furthermore, oil-refining capacity has stayed at roughly the same level for some 25 years.
In the long-term, we do not think that oil prices will exceed the $35-45 range since most alternative energy sources become profitable at those levels. Even the production of expensive bio-fuel is said be competitive at $40 and higher. On the other hand, we do not expect oil to fall far below $30 in the coming years either.
In an assessment of the impact of higher oil prices on the global economy, it is important to understand the starting position of the economy. An economy that is still operating with some spare capacity in manufacturing and in the labour market capacity will be less sensitive to higher inflation than an economy that is operating with limited spare capacity. In this light we expect that monetary policy reaction will be less pronounced than in the past.
High oil prices are acting as a tax, reducing consumers’ and corporations’ purchasing power, and will amplify the slowdown of the world economic momentum. The Fed’s assessment that the impact of higher oil prices on inflation will be ‘transitory’ is probably right. Of course, eventually, producers will pass on the higher oil prices to consumers, but these effects on inflation expectations will be offset by lower growth forecasts. The longer that prices remain high, the greater the impact will be on consumer and business confidence. In this light, expect the Fed and the ECB to become more reluctant to raise interest rates.
The International Monetary Fund estimates that a $10 a barrel increase, sustained for one year, would subtract around 0.5% from world economic growth. However, the damage done to non-oil producing emerging markets and the poorest countries would be much greater.
High oil prices strengthen our cautious stance on equities. We were globally underweight equities in July and August in our strategy funds and net short in our absolute return portfolios. We have reduced our underweight and short positions at the beginning of September but we remain on the defensive side.
There are reasons for caution:
q The global economy seems bound to slow down and high oil prices could amplify this slowdown;
q The Fed should continue to hike its Fed funds rate, which at 1.5% is still well below the core CPI;
q Earnings growth and corporate margins are expected to decline in the comings month;
q From a seasonal effect viewpoint, September is the worst month of the year;
q Markets hate uncertainties, which abound given the US presidential elections, the geopolitical and oil price risks.
If one thing differentiates the current situation from those of the past, it is the valuation level – in absolute terms but especially relative to bonds. We are still in the aftermath of the 2000-2002 bear market. Confidence in equities is still low in spite of the sharp earnings increases due to cost cutting, corporate restructuring and help from monetary and fiscal stimuli.
Should the S&P500 decline to 1010, the price-earnings ratio would be a low 15.5 (assuming 2004 earnings at $65). Earnings may, of course, decline in 2005 but this P/E ratio is an indication that valuations have the potential to become attractive. This argument is even more relevant if bond prices remain low or even decline from their current level. As an oil shock would inevitably slow down global economic growth momentum, bond yields would be more likely to decline than to go up.
Stock markets may decline in the coming months but a stock market crash (a decline of 20% or more) is very unlikely: the market will probably not decline by more than 5-10%.
Xavier Timmermans is head of product specialist asset allocation and balanced mandates at Fortis Investment in Brussels