Our impossibly complex world just became infinitely more complex.
We used to only worry about Iran and Iraq. However, recent events in the Middle East have led us to reformulate our thoughts about political risk. These riots have exposed the fragility of the political establishment of the world’s major oil exporting region. After the past month, it has become clear that the Middle East region is undergoing a demographic transition that has left the old political arrangements outdated. We are talking about two dozen countries with their own histories and cultural traditions.
If the world is struggling to keep track of 4 little PIGS (Portugal, Ireland, Greece, and Spain), there is no way investors will be able to keep track of two dozen non-western countries. So while I (and most people) can’t predict the political outcomes of these two dozen countries, I feel more confident in predicting that risk premia will be higher because of it, specifically in oil.
All that being said, it’s easy to underestimate the internal dynamics of the US economic recovery. Banks are lending, companies are investing, jobs are being created, consumers have started to consume, and productivity keeps going through the roof. Similarly, emerging markets (EM) are receiving much needed relief in food prices. Rice was down 15% from February highs.
On top of that, we still have the ongoing bond to equities trade because everyone got overweight bonds at the top of the bond market and are now anticipating tighter policy; equities and risk-on assets look good by comparison.
Our guess is that this results in a draw in the short term, a lot of range trading, a lot of volatility, and I suspect few new highs for risk assets. Unfortunately, in the short term, a large part of the outcome is dependent on two dozen countries in the Middle East. However, medium term, it’s important to remember that even Iraq during the invasion and occupation period only had three months of “shutting down” production before the oil pumps were turned back on.
Lots of curve balls to come.
- After the tax cuts were extended in December, US market participants forgot about the incoming fiscal consolidation (e.g. Wisconsin, Illinois)
- After months of better than expected data and continuously increased GDP growth forecasts, we may be genuinely ahead of the first downgrade cycle, with the catalyst being the oil price. (Unless labor markets do actually recover)
- Inflation is creeping higher around the world, and DM countries now need to seriously start thinking about tighter policy.
- QE2 will end in a couple months and won’t be replaced by QE3.
- The ECB is likely to have to hike rates in the 2H11.
The first thing to realize is that an oil shock hasn’t occurred. Oil prices being up 20% doesn’t qualify. Now, the possibility of a proper oil shock is rising, and so it’s important to go over the implications:
1. Growth: In the past, rising oil prices have been associated with sharp slowdowns in real GDP growth. In fact, every recession since 1973 either has been preceded by or coincided with a sharp rise in oil prices. An oil shock's most dangerous impact is either when there is a genuine lack of supply (not true now) or when sentiment gets seriously hit (a possibility now since the price of oil is not going up due to good sentiment about demand, but rather fears about supply).
Merrill Lynch estimates that for every $10 rise in oil prices, it cuts growth in oil consuming nations by about 0.5% over the next four quarters, with slightly smaller impacts in Europe and slightly bigger impacts in newer industrial economies. If the recent surge in prices is sustained, that would imply about a 1% hit to global growth over the next year. In the emerging markets, the picture is mixed, depending to a great extent on subsidies and pricing. In many cases, the fiscal damage can be more important than the inflation hit.
However, there are two reasons to believe that the US will do relatively better in the current period. First, the US is benefiting from a big increase in the domestic supply of natural gas, which is hard to export given the current infrastructure. Second, the US has a refining advantage. The disruptions in the Middle East generally mean less “sweet” oil production and the excess supply in OPEC is mainly “sour.” The latter is harder to refine and while US refiners are good at processing the sour stuff, Europe has less capacity and Asia very little.
For us, the same questions remain:
What is the threshold of oil prices that threatens the economic recovery? We don't know, but we are more concerned in the short-term with the future actions of the world central banks.
2. Policy: Commodity price shocks are the devil because they simultaneously lower growth and increase inflation; so neither tightening nor loosening policy can soften the impact of both effects. However, countries with greater headline leakage (EU, EM) and smaller output gaps (EM, Australia, etc) have less of a choice and are likely to need to hike policy in spite of the double whammy that can cause to growth. So how does this affect our investing policy?
3. Investment Policy Changes
- Negative on fixed income securities from non-oil exporting countries.
- We remain positive on Exxon (NYSE:XOM) and oil service companies (NYSE:OII)
- We are looking into selling volatility.