Market Opinion August 29 2005
Equities... Living With High Oil Prices
Ever since Market Opinion came into existence last year, we have been bullish on oil, stating that prices would remain high, with the risk of spikes higher. However, at the same time we have been bullish on global bond prices in general, and, at times, various stock markets. In fact, on a medium-term basis, we still like the Nikkei.
Of course, as you will have read in numerous other research notes, this time around the oil price spike is different. And it is. Firstly, it is demand driven, despite various supply side issues, with the major demand coming from one place – China. Secondly, the low cost production capabilities of Chinese manufacturers have offset the inflationary impact of higher oil prices, allowing global price pressures to remain capped. Thirdly, the G7 industrial world is far more energy efficient than it was thirty years ago. Fourthly, oil exporting nations have re-invested their windfall into US assets, and have helped stimulate global economic activity. As a result, the US has enjoyed strong growth with low inflation, and low bond yields.
Is all this about to change? The price action of the Dow Jones over the past few trading sessions would suggest that investor concern over the potential for stagflation in the US economy is a growing risk. Throw in the latest comments by Federal Reserve Chairman Alan Greenspan that he is focusing on the high price of assets – a clear indication that interest rates are still heading higher – and US stocks look set for further declines in the days ahead. The latest data certainly points to a slowdown in activity. Durable goods fell by 4.9% m-o-m in July, much more than the 1.5% m-o-m fall expected, while consumer confidence fell in August, with the University of Michigan reading dropping to 89.1, compared to 96.5 in July. Higher energy costs are starting to bite. This will, of course, take some of the frothiness out of the US housing market – music to Mr Greenspan’s ears? A similar situation has occurred in the UK, whereby a more expensive cost of living, due initially to higher interest rates, and then higher energy costs, as well as greater indirect taxation, has put the consumer very much on the back foot. Hence, the latest 25bps rate cut by the Bank of England.
With regards to the US, much therefore will depend on the Fed, and the ability to adapt monetary policy to any oil-induced slowdown in growth dynamics. This week’s non-farm payroll number will be an interesting indicator.
That said, we think the US economy is still particularly resilient in nature. In fact, thus far, the strength of the labour market, which is underpinning personal income growth, has allowed households to withstand higher energy costs, as well as spend more on other goods and services. The risk is that as higher costs become part of inflation expectations, so a slowdown in growth is required to prevent inflationary pressures from gathering pace. This is natural, and points to an adjustment in economic activity, and indeed asset prices – not a recession or a bear market.
Bottom line: The global economy has proved that it can live with high oil prices. Indeed, its very strength has more than offset the increase in energy costs. If oil rises further or remains at these high levels on a sustainable basis, we expect an adjustment in economic activity, which will be reflected in upcoming data releases Growth, although lower, will remain solid, while inflation, although ticking up, is very much under control, especially on an historical basis. There will be a natural adjustment in stock valuations, but no bear market. Commodity prices too will adjust lower under such a scenario, but will in no way collapse. Global economic activity will remain on a solid footing, and money will continue to flow to the most opportune areas, which in equity terms are several of the more dynamic emerging markets, and Europe and Japan in the G7 universe.
Indeed, despite talking about the resilience of the US economy, there is a case to be made that US equities are overvalued compared to Europe and Japan in terms of p/e ratios, dividend yields and price-to book ratios. That said, we are not overly bearish US stocks. In fact, although the Nasdaq has had a rough ride since hitting our previous 2,200 upside target, we still like the technology bourse on a medium- to long-term basis. Major support exists in 2,000 area, with significant upside potential over the coming years. We are just more bullish European bourses such as the FTSE and the DAX. However, both bourses could well be in for a tough time short term. Looking at the UK market, three-month trendline support comes in around 5,220, a break of which would suggest a move to major support in the 5,000 area. Any further easing of UK rates would render such valuations rather attractive.
Yet, the pick of the bunch is the Nikkei. Again, short-term pressures suggest a period of retracement, following the push through the key 12,000 area. Those pressures could come from oil prices, further sharp losses on the Dow, or even an additional revaluation of the Chinese currency, which would cause the yen to appreciate. Always of concern to us, though, is a market heavily positioned in one direction. This is certainly the case with the Nikkei, as foreign investors have poured money into Japanese equities over recent months. Any sell-off should meet with support in 12,200 area, with major support existing in the 11,900-12,000 area. On a medium-term basis, as we have been arguing for many months, we think the foreign investor is correct. In fiscal year 2005, the Japanese economy could well grow by over 2.0% and by 2.4% in fiscal year 2006. The outlook is definitely positive, underpinned by accelerating private consumption due to improvements in employment and income, and an increase in corporate profits. In addition, there appears to be growing support for Prime Minister Koizumi at the upcoming election. Going forward, this bodes well for the structural reform process, and the eventual privatisation of the postal industry. In fact, we see medium- to long-term appreciation for the Nikkei towards the 16,000 mark.
As for oil prices, last Friday’s sell-off on hopes that hurricane Katrina will do minimal damage to production in the Gulf of Mexico, could herald further short-term weakness. Key support for front month Brent is at US$62.00/b, a break of which could send the contract down to the US$58.00/b area. However, we see major trendline support in the US$55.00/b region. In any case, the fundamentals are still bullish. Demand in China and India remains strong. In the US, the gasoline market is tight, with US inventories declining last week to 194.9 million barrels, down 14.3 million barrels on the month. On the supply side, violence in Iraq continues, with the authorities yet to agree upon a new constitution, while tensions between the US and Iran are on the rise over the latter’s decision to maintain its nuclear programme.
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