The uptrend in the oil prices, which began at the end of 2001, has become steadily more pronounced over the last year. Brent crude, which traded between $35 and $45 in the summer of 2004, has exploded in recent weeks to hit the $70 per barrel mark.
Thus we cannot now speak of an oil price “shock” comparable in a sense with those of 1973/75 and 1979/80. Those two shocks were both associated with relatively severe global recessions.
However, while there is much comment to the effect that high petrol prices are hurting the less well off, few are predicting a global recession in 2006 on the basis of oil price developments.
Why is this? One reason may be that some investors believe that this year’s oil price hike will prove to be transitory even though forward prices for the medium term, say two years out, are still in an upward trend. This is true when looking at the rising curve of spot oil prices, which has steadily become steeper in recent months. Often in financial markets the extreme steepness of an uptrend occurs just prior to a change in direction.
A second consideration is the way the financial markets are behaving. In the equity markets, even the relatively weak US market is still slightly positive this year according to the S&P 500 index. Many European and Asian markets are up more than 10 percent in local currency terms and emerging markets are doing even better.
Crucial here are the developments in the bond markets. Despite the sharp rise in oil prices this year, yields in most government bond markets remain near historic lows. This represents a marked change in the relationship between the oil price and bond yields in comparison with the average experience of the last 40 years. Low bond yields indicate that the markets are not worried about inflation despite the higher input costs that rising oil prices represent. Although the prices of some services, such as education and medical care, are still in an uptrend mode, this is balanced by downward price pressure in many areas of manufacturing. In this context, the steady integration of low cost economies such as China and India into the world economy has a powerful deflationary impact.
These low bond yields could, of course, also be signaling some sort of economic slowdown. Clearly the purchasing power of those forced to pay higher petrol prices is being hit.
On the other hand, low bond yields, and by implication low mortgage-financing costs, are supporting the housing markets, especially in the United States. Higher house prices support consumer wealth and, in turn, support spending and economic growth. Were the housing markets to weaken in any serious manner, however, one should expect the financial markets to price in a much higher probability of recession than they currently indicate.
Encouraged by the way in which markets were coping with the combination of measured interest rate rises in the US and the rising oil prices, we increased our equity allocation to 35 percent last month.
Our base case is that markets will gradually move to anticipate an end to the process of higher US rates and that rising interest rates elsewhere are some way off. A pull back in oil prices, if and when it happens, could also be very supportive for markets.
Having said that, our asset allocation remains a cautious one with 45 percent in bonds and cash and a further 20 percent in alternative investments, the majority of which is being allocated to low risk fund of fund investments.
While energy remains a core component of equity portfolios, we no longer predict near-term outperformance and have removed the sector from our favored list. We suspect that “higher beta” areas, such as emerging markets, IT and biotech, will lead further market advances in the near future. Nevertheless, we continue to advocate a broad spread of equity investments across the main industrial sectors.
Finally, on currencies, we recommend hedging foreign exchange exposure back into the domestic currency. However, over the summer months and into the autumn, we expect some reversal in the US dollar’s recent gains against the Japanese yen.
(Habib F. Faris is vice president at Clariden Bank, London.)
(The information contained here in is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information.)
