Sector, Macro

Oil: How Much of a Threat?

March 14th, 2011 | By Nick Sargen

Overview

On the second anniversary of the bull market in equities, it’s worthwhile to reflect on how far the markets have come since the financial crisis and also on the risks that lie ahead. Foremost on my mind is the uncertainty posed by developments in the Middle East/Africa and the risk of an oil supply disruption that could send oil prices higher.

I do not believe the recent spike in oil prices of $20-$25 per barrel poses a serious threat to the global economy at this time. Consequently, I am content to hold on to existing equity exposure. That said, if turmoil were to spread and lead to further increases in oil prices, I would reassess our strategy, especially if confidence of consumers and businesses were undermined. I am alert to this risk, because throughout my career, oil price shocks have contributed to global recessions and bear markets, and this possibility is not priced into markets today.


A Brief Look Back at the Rally

Looking back, it’s hard to believe that U.S. and world equity markets have recouped all of the losses posted after Lehman Brothers’ collapse. A global rally of this magnitude in such a short period is without precedent since the Great Depression. Even more telling – no one anticipated it.

Therefore, I find myself asking the following question, “Is this rally for real; or could it be unwound?” My assessment is that the rally has solid underpinnings, but it is also rare to see a market advance in a straight line. Therefore, investors should be prepared for pullbacks along the way.

When the rally began in March of 2009, the U.S. and overseas economies were contracting at a rapid rate, but actions by the Federal Reserve and other central banks were helping to stabilize credit markets and money markets. Confidence in the financial system was boosted further by the announcement of stress tests for large U.S. banks, which indicated the capital shortfall needed to ensure the soundness of the system was less than many investors had envisioned. Thereafter, equity markets rallied steadily from mid-2009 through the first quarter of 2010 as the global economy recovered and corporate profits rebounded.

A major test for the markets occurred in the spring and summer of 2010, when worries about Greece spawned concerns about the viability of European Monetary Union and the U.S. economy lost momentum. By late August, worries about deflation and a “double-dip” were rife, and the U.S. stock market plummeted by more than 15% from its peak. This led some observers to question whether the bull-run was over.

Since then, the U.S. equity market has been on a tear, rising by about 30% without any interruption. The catalyst was the Fed’s launch of QE2 in September, which was followed by an extension of the Bush tax cuts in November. On the economic front, the latest data points to a broadening of the expansion in the past two quarters, while corporate profits have surged above their peak before the financial crisis. Consequently, until very recently it was difficult to identify an event that could cause the market to reverse course.


Implications of Middle East Developments

Against this backdrop, the developments in the Middle East/Africa and in oil markets represent the first real test for equity markets in six months. Thus far, the markets have taken the news in stride and have not over-reacted to the situation. In fact, investors quickly shrugged off the political unrest in Egypt, and there has only been a muted response to the fallout from the developments in Libya.

This raises another question for me – namely, is it rational for investors to shrug off a $20-$25 spike in oil prices; or are they being complacent about a potential risk?

My take is that it’s one thing to ignore a price hike of this magnitude if you are very confident it is temporary. However, I’m also cognizant that what is happening in the Middle East/Africa today is unprecedented, and the risk of a disruption in oil supplies spreading to other parts of the region has increased. I am sensitized to this possibility, because prior oil supply disruptions – the 1973 oil embargo, the 1979 Iranian revolution and the 1990 invasion of Kuwait – culminated in recessions and bear markets in equities.

At this juncture, it is too early to sound alarm bells, as the magnitude of the recent oil price hike is well below those cited above. Also, Saudi Arabia has ample spare capacity (3.5 million bpd) to offset the shortfall in Libya’s production. Based on the rule of thumb many economists use that every $10 per barrel increase translates into a reduction in real GDP of 0.2%-0.3%, the recent price hike, if sustained, would lop off about 0.5% from U.S. economic growth, which is projected to be between 3.5%-4.0% this year.

But the picture could change quickly if turmoil in the region led to bigger cutbacks in oil production. Many observers have queried about how much oil prices would have to rise before the global economy reached a tipping point. My assessment is that it is very hard to make a precise determination, because several other factors need to be considered.

One factor has to do with the state of the world economy. In this regard, I believe the global economy is in better shape to absorb a shock today than it was in 2008, when the U.S. economy already was in recession and financial conditions were deteriorating rapidly.

Another factor has to do with the nature of the policy response. In prior oil shocks, for example, central banks countered the inflationary impact by tightening monetary policies, which added to downward pressures on their economies. Today, however, the response is likely to be more varied. The Federal Reserve views the recent oil price hike as a one-time event, and is committed to keep interest rates low, while the European Central Bank has signaled that it is prepared to raise interest rates at its next meeting.

Finally, a lot hinges on how consumers and businesses react. One of the factors supporting the equity market is that households and businesses are becoming more confident that the economic expansion will continue. The risk, however, is that confidence could erode if oil prices were to rise by another $20-$25. Even if such an increase does not result in a “double dip,” it could cause the economy to lose momentum.

In summary, my bottom line is that while equity markets have been able to hold on to their gains thus far, there is a risk that oil prices could rise further. I’m not advocating making changes to portfolios at this time, but one should not be complacent about what is transpiring in the region. And I would consider lightening equity exposure if the turmoil continues to spread.