Investment Management in ET*
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*Life beyond oil.com*
*Life beyond oil.com*
Decelerating economic growth could be good news for inflation-obsessed stock markets as it puts further downward pressure on commodity prices
movement; at one level it appears as if nothing is happening but just
beneath the surface a lot of particles are churning that may suggest the
character of the market is indeed changing.
While global equity prices at the aggregate level have been virtually
unchanged over the past month, the real story is that almost every trend
which defined the first half of the year is turning on its head, thereby
setting the stage for an end to the bear market regime. Commodity prices
have witnessed one of the sharpest declines in recent times while financial
stocks are showing signs resilience even in the face of all the dire news
still emanating from that sector. Such a turnaround in the fortunes of these two sectors is necessary to ease the stagflationary angst plaguing the system. Just a month-long setback in some deeply entrenched trends may
signify nothing more than a temporary shakeout. However, given how extended
the trends had become, the reversals in July probably marked a major turning point — when momentum snaps after it's been stretched to an extreme, it usually breaks for good.
To put it all in a long-term perspective, the price of oil over the past
decade has risen by a magnitude similar to the Nasdaq between 1990-2000. By
June this year, the relative out-performance of the energy sector had far
surpassed the 1970s experience. The only other time one sector was able to
pull so far away from the broader market was when tech stocks topped the
league table in early 2000.
There are fundamental reasons in play that suggest a pronounced bear market
in oil and other commodities has begun. The third quarter of this year will
probably mark the first time in the current global expansion that oil
consumption growth turns negative on a global basis. Oil demand in OECD
countries is now contracting at 3% on a year-overyear basis. With the OECD
still accounting for more than 50% of global demand, even if emerging market demand continues to grow at an unlikely pace of 3%, it will not prevent overall oil consumption from declining. Furthermore, there's growing evidence to suggest China is joining the economic slowdown and global industrial production growth could slip to below 2% by year-end — an
environment that has typically been hostile for all commodities including
oil.
Changes in demand patterns of oil tend to be very sticky. If history is any
guide, then the price of a commodity reverts to its marginal cost of
production once demand for it turns negative. In the case of oil, that price would at best be $80 a barrel (using a conservative estimate based on the typically high price of Canadian oil sands). The $80 level also marks the point where the oil prices went into a spiral last November and started to destabilise global equities.
Of course, the oil bulls argue that focusing on demand patterns is
misleading as the real problem is that crude supply is struggling to grow.
While there is some merit in that argument, given the rapid depletion of
existing oil fields and limited spare capacity, the most important point to
remember is that whenever oil demand has turned negative, it has always led
to a bear market regardless of the supply situation. Even in the 1970s, the
big price spike in 1973 due to geopolitical tensions resulted in oil demand
turning negative the following year and a subsequent cooling off in oil
prices.
It takes a while for major trend reversals to become apparent and
building tops is a complex process. The Nasdaq in 2000 declined sharply from its high point in March that year but there were so many comeback attempts that even as late as September the index was only 10% below its all time high. However, by the end of the year the Nasdaq had halved in value and the psychology of ever rising prices was truly broken. Similarly, it's possible that after hitting the point of demand destruction oil could be back at its marginal cost of production of $80 a barrel by the end of this year. However, the journey to that point could be volatile with many countertrend rallies.
While oil tends to grab the headlines, a much less discussed but even
more significant development with regard to the inflation outlook in
emerging markets is the recent behaviour of agricultural commodities. Prices of several commodities from wheat to rice are down by over 30% from the high point in March-April this year. Just as hysteria was building on how the world is running out of food — and all sorts of Malthusian arguments were being loosely bandied about such as "the world is losing one hectare of arable land every 8 seconds" and that "only 3% of the world's surface is arable" — it seems a massive supply response was on its way that has now led to a sharp decline in agricultural prices.
Based on these trends, it's likely that inflation is close to rolling
over globally. The base effects are expected to become favourable by the
fourth quarter of 2008 as the commodity price surge began in August last
year. And if commodity prices continue on their downward trajectory, a lot
of the inflation angst should dissipate by the end of the year. A meaningful improvement in the global inflation profile will undoubtedly
be positive for equity markets. It will also imply that the reversal in the
relative country and sector performance trends seen in July marked a regime
change. There is reason to believe that the second leg of the credit crisis
that began in mid-May, just when equity markets were in the midst of a
spring thaw, was largely due to oil prices surging at an even faster pace.
As central banks across the world became increasingly uncomfortable with
high headline inflation and the acceleration in oil prices, they were forced to adopt a more hawkish stance. In the US too, the perception grew that the Fed may have to consider raising interest rates to maintain its
anti-inflation credibility, which in turn stoked fears of a more severe
credit crunch.
To be sure, commodity prices are currently falling due to rising concerns that global growth is slowing with the red-hot emerging markets too coming off the boil. This begs the obvious question of whether equity markets will be able to rally in the face of a slowing global economy. Historically, stock prices almost always move ahead of the turning point in the economic and earnings cycles. At previous inflection points in global equity markets, stocks often rallied six months before analysts were done with the downgrading process. Valuation measures such as the price-to-earnings — or P/E — ratio are very sensitive to changes in inflation and interest rates; they usually expand first in anticipation of a better economic outlook and earnings growth follows.
If inflation does indeed prove to be just a food and energy problem and
does not lead to a price-wage spiral then the relevant template for the
current emerging market boom would be US market behaviour in the late '80s
and early '90s.
The US enjoyed a secular bull market from 1982-99 where the market
compounded at an average annual rate of 18%. However, the uptrend was
punctuated by some sharp corrections including an oil price spike and a
credit crisis-induced bear market in 1990. A surge in oil prices following the first Gulf War pulled US inflation up from just below 4% in 1989 to 6% by the end of 1990. The economy faced a mild recession and the recovery was tepid with the economy expanding below trend in 1991 and 1992. However, once inflation peaked and the Fed contemplated cutting interest rates, the market rallied strongly even in the face of weak economic news.
Similarly, emerging markets could rally into this year-end as inflation
fears recede on the back of declining commodity prices even though the news
on the economic growth front is likely to get worse. Given the inflation
concerns, bad news on growth may well turn out to be good news for markets.
The key for such a roadmap to hold together is for the commodity downtrend
currently underway to continue to chart the path of the tech in 2000. So
far, the parallels between the two — the Nasdaq and oil — fit rather neatly.
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