In the past few weeks, turmoil erupted across the Middle East raising the specter of escalating oil prices, which in turn might cause the global economic recovery to be stopped in its tracks. While much of the current unrest had its genesis in public anger over rapidly rising food prices, energized people quickly escalated their demands for the overthrow of corrupt and unrepresentative governments. We believe these budding Middle East and North Africa revolts have opened the door to chaos for much of the region for an indefinite period of time into the future. Fortunately, the combined GDP’s of most of these economies, so far, is of little consequence to global growth. Unfortunately, oil is the primary export of the region, and the threat of supply disruptions has sharply increased the price of oil in a relatively short period of time.
Presented below are our thoughts regarding rising oil prices and their impact on our continuing economic recovery. We also examine current indicators of future inflation to determine if investment markets are sharing the same concerns as are being voiced by media commentators and other talking heads.
BCA Research has studied the relationship between changes in the price of oil during the past 40 years and the change in price of the S&P 500 Index. BCA concludes that “it usually requires oil prices to double before the world economy is brought to its knees and stock prices go into a cyclical bear market.” Other research reports we have seen have arrived at substantially similar conclusions.
As shown in chart 1 below, oil prices doubled in 2009 from approximately $40 per barrel in January, to approximately $80 per barrel in December. Investment markets took this recent price increase in stride however as the price increase reflected a return to global growth and a more normal pricing environment as fears of a total global meltdown were rapidly subsiding. In addition, the increase took place more or less evenly over the course of the year as opposed to happening in one fairly rapid price spike.
We recently completed an approximate one-year period (2010) in which oil prices stabilized in a range from $70-85 per barrel. Last week however, prices for West Texas Intermediate Crude (WTIC) spiked to close to $100 per barrel. If we apply the BCA observed historic relationship to last year’s price range, prices would need to rise to the $140-170 level before the U.S. might experience a new recession. Of course we would expect the stock market to turn bearish before that point, but it seems premature to become heavily defensive at this moment.
Our biggest energy nightmare involves the potential for decline into chaos on the part of Saudi Arabia. Libya, Bahrain, Tunisia and Egypt are not significant oil producers. Saudi Arabia on the other hand, is the 800 pound gorilla of the oil patch.
We have seen reports which claim 40% of Saudis live in poverty and nearly 70% cannot afford a home. As is true in other Middle Eastern hot spots, the Saudi ruling family is Sunni while Shiites make up a large percentage of the underserved population. The ruling members of the Saudi family are old and ill and there are no clear cut lines for succession to the throne. No one could be happier about this situation than majority-Shiite Iran which waits eagerly to sow the seeds of discontent and revolution in both Saudi Arabia and its close neighbor, Bahrain.
Under that scenario, major commodity exporting countries in Asia, Latin America and Africa would suffer the consequences. Emerging market stock markets have sold off around the world. Spillover effects would affect various American companies in similar fashion.
We continue monitoring the price of oil futures, interest rates, inflation expectations and the fear of"“descent into chaos" in Saudi Arabia (through its credit defaults swaps). As we write this letter however, we are pleased to say that alarm bells are not ringing for either the U.S. recovery or for an oil catastrophy. Nevertheless, we are not sanguine about longer-term prospects in the Middle East. As Bret Stephens of the Wall Street Journal writes, "It’s not enough to be for something at least in the sense in which the Arab world now seeks a freer and more representative political dispensation. What’s required is the statesmanship that can give concrete form to a hazy political dream."
One need look no further than regime change in Iraq, and Iran before that, to see the difficulty of creating a government representing all the people and operating with a degree of transparency. Other than Israel there are no democratic regimes in the region, and the threat of Islamic extremism under theocratic despots may quite possibly be the emergent form of any number of new governments birthed from these current revolts.
Is the recent spike in the price of oil an inflationary event to the U.S.? In our opinion, the answer is, no! Our economy is still too weak with unemployment at current levels and manufacturing capacity far below optimal levels for an inflationary psychology to take hold. A stronger argument could be made that a continuing rise in the price of oil could eventually precipitate a deflationary situation if our recovery is knocked off track. Our bond markets will give an early warning if the specter of deflation begins to materialize.
As one might expect, people differ in their thoughts about the causes, and even the definition, of inflation. It is the opinion of members to the Federal Reserve that inflation can be observed when there is a general increase in the price level of a large cross section of goods and services in the economy. An increase in the price of a single commodity, or even a few commodities (such as food items) does not in itself constitute an inflationary event. Furthermore, until higher prices pass through into escalating wage demands, a general outbreak of inflation is unlikely.
Presently, inflation expectations, as measured by various fixed income indicators remain subdued. Thus we believe the economy remains, for the moment, in a low inflation, low growth and highly monetarily stimulative environment. This environment is conducive, as it has been for more than a year, to further stock market gains.
As our longer-term clients are well aware by now, we pay little attention to the constant deluge of opinion offered in mainstream media. Instead we observe the reactions of global financial markets to unfolding events. Presently, markets remain relatively unaffected by Mideast turmoil with, of course, the notable exception of the price of oil. As we have stated many times in the past, a problem isn't a problem until it is a problem. However, just as a good chess player strategizes the game multiple moves ahead, the art of investing also calls for strategizing various possible outcomes that may be played out in the future, and then timing one's moves accordingly.
Given the possibility of social disintegration in Saudi Arabia, and our pessimistic view regarding the peaceful transition of the region into a group of countries supporting democratic ideals, we have over the past few weeks, been increasing client exposure to the energy sector – including oil, gas and coal. Furthermore we continue to assess the price effectiveness of hedging a portion of client equity portfolios.