REPEAT Rudi’s View: Don’t Make That Mistake

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(This story was originally published on Wednesday, 2nd March 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).

– Investors thinking this is but a temporary oil problem because of Libya are in for a rude awakening
– Public debate is raging about what the Fed will decide if QE2 expires in June
– Chinese economy is slowing and we might see PMIs contracting in Q2
– GaveKal research shows periods of high growth are usually not good for share market returns

By Rudi Filapek-Vandyck, Editor FNArena

I have been saying this for the past three weeks: investors were too blinded by uninterrupted gains for US equities, and they were so willing to put everything else aside that they chose to ignore one of today's future hallmarks. One that has seen the removal of two long-standing dictators within a matter of days from each other, while a third is about to also go down as a foul smelling footnote to modern history. Who's to bet the buck stops with Libya?

Last Friday, as three guests and the program host were wrapping up the Friday Afternoon Round Table in the new TV studio next to the BoardRoomRadio offices, there was the prevailing view that all this was simply a storm in a tea cup. We'll all soon be buying again, Clifford Bennett and John Murray nodded towards each other. Viewers who kept their browser open and the sound on until the final seconds of the broadcast would have witnessed that I warned both against too much complacency.

Many of you will remember I kept a high profile, contrarian view throughout the oil craze of 2008, one that ultimately saw my warnings come through, and then some. At the time I couldn't help but wondering why I was the only one who continued pointing out that a doubling of the oil price in less than twelve months would be guaranteed to push the global economy into recession. Where were the others in this debate, I wondered in 2008. This time around, however, there's plenty of attention on oil possibly spoiling the nascent economic recovery in developed economies (or should we worry more about developing economies?). This raises even more the question: where were all those people three years ago?

It also makes me suspicious whether this time around markets are again responding in the wrong fashion, albeit in the opposite direction?

In support of recent share market weakness: last year economists re-ignited the debate over the level a rising price of oil would start hurting economies and the prevailing view was that anything north of US$110 per barrel would start inflicting some real pain. Brent oil, and other more representative benchmarks than WTI these days, have already traded above this pain-threshold. A more logical conclusion therefore seems to be this might well be the real McCoy, not just a storm in a tea cup.

I'd still be inclined to say that share markets are probably showing a little too much weakness, given oil is only around US$110/bbl just yet, but it's all about what comes next, and about what could come next.

Note: the widely quoted "prediction" by analysts at Nomura that crude oil prises could spike as high as US$220/bbl is simply -once again- the media creating their own reality. Nomura has said that if two fringe oil producers, like for instance Libya and Algeria, were to temporarily cease production, then oil might as well rise as high as US$220/bbl. You would all have noticed the conditional preface to that figure is seldom being mentioned. At present, not one oil producing country has stopped pumping and supplying. Not even Libya.

At present, it's not about what is, it is about what can be the new reality tomorrow and this is why investors are ignoring economic data, corporate results and anything else that could possibly stand in the way of the present focus on oil.

The irony: this is the complete opposite of what was happening in December, January and in early February. This probably means that, bar a deterioration of the situation in the Middle East, and thus a higher oil price, the present weakness will provide a platform for the next relief rally.

The only problem with this scenario is there are plenty of experts around who believe oil will not retreat from these elevated levels anytime soon.

The main problem, as I see it, is that investors will be swayed into the idea that share market weakness is all about oil, and nothing else but oil. A few weeks ago I wrote about investors debating what will happen if QE2 is not followed up by QE3? Are equity markets strong enough to withstand the loss of the Fed's natural support?

The world's number one fund manager, Blackrock, sent its Managing Director, Global Head of Fixed Income, Peter Fisher (ex-Fed and ex-US Treasury) to Sydney this week to share his views on global growth and interest rates. Fisher agrees the US is by no means ready to start thinking about tightening just yet (and won't be for a long time), but Fisher also believes that once financial markets start concentrating on what the Fed's going to do at the end of the second quarter, things could get "interesting". That moment is drawing closer every day and there is no agreement whatsoever other than that Bernanke and Co don't seem to have any intention to close their quantitative easing program before the due date, which is about three months away.

Fisher suspects the Fed will continue using its balance sheet to support the markets, just not in a similar fashion. And it won't be a QE3.

Others are not so sure. However, if the experience from last year is anything to go by, the Fed will show little hesitation in jumping back into action if and whenever the withdrawal of its support leads to sharply weakening asset prices. Remember what happened last year between May and August? And then Bernanke's market saving speech in Jackson Hole later that month?

Things may not be as simple the third time around though. Some experts have already predicted the Fed will find the market might no longer play along the day QE3 is announced.

The one debate that is at present receiving no airtime at all is the slowing economy in China. One thing is certain though: investors are (slowly) getting the message. China will slow down. The Chinese government wants a slowdown. The only remaining question, as Macquarie economists put it this week, is by how much China will slow down – it's no longer a question of "if". Interestingly, the above mentioned Peter Fisher suggested that, ultimately, what China might consider as being a soft landing (7% GDP growth) might possibly look too hard for the outside world. Fisher was referring more to 2012 than to this year.

Judging by what economists at Danske Bank put on paper this week, the China debate could equally get "interesting" over the next weeks and months. Danske Bank economists have already seen sufficient evidence that growth in China is due for a noticeable slow down. This is, in fact, already happening with both purchasing managers' surveys for manufacturers earlier this week signalling slowing growth. Was it pure coincidence the independent HSBC index showed a more significant fall than the official survey?

What caught my eye was that, if Danske Bank's projections prove correct, both monthly PMI surveys will end up below 50 in about three months' time. I don't want to turn myself into the scaremonger du jour, but I very much doubt whether share markets are strong enough to deal with a contracting manufacturing sector in China. This smacks of rough times ahead for resources companies, and probably for risk appetite in general.

Incidentally, I have noticed overseas asset managers have started to remove the likes of Rio Tinto ((RIO)) off their Most Preferred lists. Hedge funds, such as Antipodean Capital Management, earlier this year already reduced their exposure to equities to zero. At Blackrock, market strategists maintain there's further upside for equities in 2011, it just won't be smooth sailing. (See below for Blackrock's Top Ten Predictions for the year).

And while the whole world is nervously watching what is going to happen to Fed supported liquidity in the US, Macquarie analysts point out on Wednesday morning there is increasing evidence the Chinese central bank is taking liquidity out of Chinese markets. This, say the analysts, is the real tightening in China that has received no attention at all thus far. The result is that Macquarie expects we will see a real buyers' strike at smaller steel mills within the next three months and this is likely to see iron ore prices tumble from very high levels.

That said, Macquarie also remains of the view that iron ore demand remains sufficiently strong for prices to recover relatively quickly afterwards. Needless to say: history shows that in a market where everyone is travelling on the same commodities trail, small bumps in the road can have significant effects in the immediate term.

Further analysis by GaveKal takes us back to the petroleum theme. High economic growth (as we are experiencing right now with data and indicators at multi-year highs) is usually not a good time for investment returns in the share market, reports GaveKal. That's what history shows. And things do only get worse when oil is rising in price at the same time (which can be expected, given strong growth). Thus, says GaveKal, today's challenge is that if the recent escalation of oil prices continues much longer, then one might fear another financial catastrophe, if only because governments are much more vulnerable today than they were three years ago.

Investors better not make the mistake of assuming this is just about one deluded dictator who has decided to stay in power for longer than the world wants him to be. In GaveKal's words: "it is hard to avoid the conclusion that increasing risk at this juncture will not prove rewarding".

To put it bluntly: It's risk off.

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website. 

P.S. II As promised above, here are Blackrock's Top Ten Predictions for 2011:

1. Equities will outperform cash and bonds

2. Resources will continue to outperform

3. Taiwanese equities will outperform

4. Canadian 2-year bond yields will rise, relative to those in the US

5. Interest rates will rise in Asia ex-Japan

6. The US yield curve will flatten

7. The AUD will underperform other commodity currencies

8. USD will outperform Yen

9. Asia ex-Japan currencies will outperform

10. Oil prices will continue to rally

 

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