FYI | Jun 11 2008
The market is in doubt. Not sure which way to go next. At least that’s what market commentators elsewhere are telling you.
I don’t believe this is the case. I think part of the investment community knows exactly where to go, while the other part hasn’t seen the light yet. The end result is the same: a fairly stagnant share market. The explanation isn’t.
I am genuinely surprised by the fact that many an investor -small, smaller, larger and large- has not yet made the connection between high oil prices and slower economic growth. I remain convinced that those who refuse to pay attention will get caught out at some stage.
With oil prices remaining in the vicinity of US$130 per barrel, and a large army of cheerleaders continuing to point in the direction of US$150 and higher, I think the most logical conclusion to draw is that economic growth is going to disappoint in the months ahead. Mind you, this is after we’ve already seen growth forecasts coming down significantly over the past months.
Are equity markets reflecting such a scenario? Of course not. One of the most favourite sentences I come across in intelligent research reports these days is “equity investors are/seem in denial”.
Today an enthusiastic professional investor asked me whether I thought crude oil might go to US$150 per barrel. I responded with: it might, but don’t be surprised if you’ll find the ASX200 at 4900 then.
Silence.
I could tell he hadn’t made that connection yet. I know for certain that an increasing part of the global investment community is making the connection. I can tell by the amount of research reports that land in my inbox, or are cited elsewhere, containing key terms such as “slower growth projections”, “higher costs”, “less spending”, “diminishing confidence”, “higher inflation” and “rising interest rates”.
As I have been trying to get across over the past few weeks, and I am more than happy to say it again:
HIGHER OIL PRICES ARE NOT GOOD NEWS.
Apart from cutting into spending budgets (consumer budgets but equally so in corporate budgets), high oil prices push up headline inflation numbers, force governments and central bankers into action (the “negative for economic growth”-type of action), but above all, expensively priced oil competes with high interest rates as the most dominant factor when it comes to exerting a negative impact on consumer confidence. No surprise thus today’s release of the Westpac-Melbourne Institute June consumer confidence index has revealed confidence for the average Aussie battler has now sunk as low as it was back in 1992 – recession level deep.
High oil cuts even deeper into budgets in developing economies, especially with governments starting to abandon official subsidies. Next thing you know central bankers start raising interest rates. We all know what comes next. Slower economic growth.
This immediately explains why some strategists are pulling the old valuation argument out of their bottom drawer when it comes to banks. Banks are cheap. Sure, they are facing tough times, and earnings growth will remain far, far remote from what they were used to until last year, but they’re cheap. And they pay good dividends.
Compare that with growth oriented companies who do not have a direct (positive) leverage to expensive oil. Many of them have outperformed over the past months. All of them are now vulnerable because valuations are higher than the market average and economic growth is poised to disappoint. Not just in Australia, or the US, or Europe, but also in developed countries.
Take a good look at the charts we recently introduced on the FNArena website. Under the section “Commodities” there’s only one chart that shows a steadily increasing path, the one that depicts crude oil futures since January this year. All the others, from copper to nickel to uranium to zinc, show a steadily fall in prices since April (ok, tin is the exception, but it is falling now).
These charts are in line with experts pointing out it would seem fund managers are scaling back their exposure to base metals. This brings me back to the second paragraph: part of the investment community knows what lies ahead, and they are repositioning themselves accordingly. (Consensus has it that aluminium and copper should be ok, the rest is in for some more bad news flow).
There are more reasons to assume share markets are likely to find the going tougher in the near term: phase next in that dreadful credit and debt problem amongst global banking institutions is likely to bring some more negative news out of corporate closets. Next thing you know housing markets sink a little deeper and the whole carrousel of write-downs, provisions and new capital raisings is back on the agenda.
Some economists believe the second quarter might well turn out the weakest for the US economy this year. Those second quarter data are the next ones to hit the public arena.
No wonder thus that global strategists at Credit Suisse this week suggested they could see equity markets fall another 5-10% from current levels, before bouncing back and ending the year higher. Credit Suisse sums it up as follows: “[global] GDP growth has to be slow enough to stop commodity prices rising yet fast enough to justify earnings estimates. These two objectives are now increasingly looking incompatible”.
Central in Credit Suisse’s thesis is the fact that the combined burden of interest rates, food prices and expensive oil is now comparable to where it was prior to the hard landing of 1990. And for those who remain yet unconvinced that investors more so than market fundamentals are responsible for today’s price levels for crude oil, here’s something to think about from Credit Suisse:
“We are surprised to see oil rise so sharply when US miles driven are declining for the first time since 1980 (North America accounts for 29% of [global] oil demand)”.
What is the common key factor behind each and every investor mania? Precisely: factors that should temper enthusiasm are simply ignored, while all other factors are seen as another reason to buy.
Just make sure you don’t end up on the sorry side of the market in a while from now.
Till next week!
Your editor,
Rudi Filapek-Vandyck
(As always firmly supported by Greg, Todd, Grahame, Chris, Joyce, Paula, Sarah, George and Pat)
