THE resilience of equity markets in February has been highly remarkable.
In spite of the unsettled political situation in North Africa and the Middle East, so close to the source of so much of the oil that represents the life blood of our industrial economies, global equity markets have managed to rise, albeit marginally (+2% in Dollars) over the month.
At the same time, United States and British government bonds have maintained their sang-froid in the face of an inflationary challenge from both energy and food prices.
A “rule of thumb” from the past would suggest that the rise of over $20 in oil prices over the past three months (from $92 to $113) will reduce global economic growth by 1% – a meaningful amount. So why are investors shrugging off what should be some disturbing factors?
Simplistically, we think that there are four principal reasons that are justifying looking past this situation.
The first is that the base level of expectations for 2011 global economic growth has been quite high (over 4%). This means that we can afford a modest shock and still experience decent growth.
Secondly, while there has been poor news from commodity markets, there has been material offsetting good news. Specifically, recent employment data has provided strong evidence that America’s commitment to engineer a recovery at any price is succeeding.
Thirdly, the flows of money over the past three years have overwhelmingly been out of equities (risky assets) and into bonds – a trend that has only very recently begun to reverse. This means that, for all that sentiment surveys have indicated a degree of complacency in the short term, investors are in reality already holding relatively “risk averse” positions. Many now perceive systemic risk to be declining, or indeed “inflation risk” to bond positions to be rising, so they are looking for opportunities to moderate this stance.
The final reason investors may have for their patience is that they believe that the political and economic uncertainties will pass quickly, or that in some way the risks are being overstated.
The logic for this relies mainly in believing that Saudi Arabia, the world’s biggest oil producer, will remain stable, since that country can supply any likely rebellion-induced shortfalls to oil supplies from excess capacity, provided they are inclined to do so.
On a slight tangent, recent commodity price rises are bringing a serious structural issue in markets to the fore. This is the degree to which speculative activity, enabled by new financial products, has exacerbated the situation. This is not just of academic interest. In past commodity cycles, it could have been argued that financial innovations (such as commodity futures) have acted as beneficial and stabilising influences. Recent products have, however, opened these markets to a vastly wider range of participants. This has empowered a much deeper pool of speculative capital with the capacity, at least in the short term, to overwhelm the price signals generated by fundamental conditions of supply and demand.
Why does this matter? Simply put, it matters because such things as food and energy prices are frequently not dependent upon economic activity levels, but contributing determinants thereof.
Government and regulators need to be alive to the risks of allowing unfettered growth in such products. Investors need to be alive to the risks of failure to regulate by those same parties.
John Haynes,
Head of Research,
Rensburg Sheppards
