A barrel of crude oil may cost more than $30, but investors in US shares need not panic. While a soaring oil price may have spelt danger for the stock market in past cycles, this time things are different, equity strategists say.
Merrill Lynch’s chief US investment strategist Christine Callies says in her investment strategy report that elevated prices for energy products should not have the same negative impact on equities as they did in past market cycles.
Climbing energy prices represented a threat in past bull markets because they prompted the US Federal Reserve to raise interest rates. But that type of policy response is unlikely this time, Callies argues.
Also, corporate profits and margins are not as sensitive to rising fuel and utility costs as is generally expected, she says, as only a few industries consume large amounts of energy input per dollar of output.
So the impact of spiralling fuel costs on equity prices may be minimised during this cycle. But there is still little doubt that the higher oil price has put a damper on the summer rally enjoyed by US equities this year, strategists say.
In the past few months, investors have been busy rotating from growth stocks towards value stocks, but this pattern has now largely petered out, strategists say. This shift benefited the Dow Jones Industrial Average at the expense of the technology-laden NASDAQ index.
However, buying interest has more recently homed in on banks, partly because bond yields have fallen. Persistent rumours of planned mergers in the sector have further fuelled the rally in financials, says Chris Johns, global strategist at ABN Amro. And in mid-September, these hopes became reality when Chase Manhattan announced its intention to buy JP Morgan.
Other stocks to gain from the trend towards lower bond yields were utilities. Utility stocks attracted buyers because they are seen as proxies for bond yields, says Johns.
In general, the market is in waiting mode. Investor confidence will depend on how the sluggish US economic situation pans out. Some believe the weak economic figures out so far could simply reflect a temporary slowdown, which is usual in the second quarter of the year. Others see the weakness as a longer-lasting, but nevertheless shallow economic dip.
“The whole market is discounting a perfect landing and we think there’s a lot of room for error in that,” says Gail Dudack of UBS Warburg in New York.
Already in September concerns have surfaced about corporate earnings, and the weak euro has lowered the translation of some foreign revenues. Other risks include the possibility that the economy could slow still further in 2001 and that the Fed could raise interest rates. “The market has not discounted that yet,” says Dudack.
“The markets have gone very defensive,” due to the economic slowdown in the US, says Johns. All sectors not exposed to the economic cycle – such as pharmaceuticals and consumer goods – have benefited from the change in mood, he says.
With the US presidential election looming, the political future is not clear, and question marks remain over the oil price and the economy. “If all of these things settle down, then there is room for growth in the market,” says Johns, although he forecasts the S&P 500 index will stand at around current levels of 1,480 in six months’ time.
Dudack predicts the NASDAQ will re-test its lows over the next few months.
“The NASDAQ is the most vulnerable in the US, with the Dow representing the best value... we don’t expect uniform performance,” she says. The market’s momentum is currently value-driven, and that will continue, she adds.
She forecasts the DJIA will end the year at around 10,000, the NASDAQ at 3,200 and the S&P 500 at around 1,350 – all down on current levels.
The bond market, too, seems stuck in limbo. Judging by interest rate futures contracts, the market appears to believe the Fed is not going to tighten monetary policy for two or two and a half years, says David Knott, fixed income strategist at Deutsche Bank.
“What that means is people are not very clear about where they will go,” he says. Many in the market are now questioning old economic assumptions and taking a wait-and-see approach. “Not very much has impacted the bond market... people do not have a strong conviction that the standard feedback mechanisms now apply,” says Knott.
Suggestions made in the wake of recent weak employment data that the Fed may move to ease borrowing rates by the end of the year are wide of the mark, says Kenneth Hackel, chief US fixed income strategist at Merrill Lynch.
Such a move is unlikely because the economic slowdown has been moderate so far, and also an easing by the Fed could re-ignite growth by causing a stock market rally and a renewed acceleration in the housing market, he says in a report.
In the absence of strong signals from the Fed, the energy market or the political arena yields on ten-year US Treasuries are likely to remain stuck at around their current levels of 5.77 per cent, he says.

Topics