The events last week gave credence to the geopolitical risks that are facing the world. In Libya, the uprising caused financial markets all over the globe to sell off, and the price of oil to skyrocket. However, in the United States consumer confidence in February reached a three-year high, but no one really took notice. Will the turmoil in the Middles East cause enough disruption to derail the fragile economic recovery? Moreover, can the US government come to a fiscal budget comprise to avoid a government shutdown by March 4th?
Over the last six months, the financial markets have not reacted negatively to any sort of bad news around the globe. Ireland, Spain, and Greece are nearly bankrupt. Moody’s and Standard and Poor’s have threatened to downgrade nearly every developed country’s debt rating. The state governments within the United States have substantially cut their spending budgets for the coming fiscal year, and there is the threat of a US government shutdown if congress does not agree to raise the debt ceiling from the current $14.7 trillion level. So, why all of the sudden does the stock market sell off nearly 4.0% in three days last week?
The answer is simple: OIL.
Anytime, there is a threat of higher oil prices the financial markets go into a panic. Higher oil prices are a direct tax on consumers and businesses. The higher the costs of inputs and the higher the cost of gasoline, consumption is directly affected and an economic strain is the result. The only country in the world that has any real excess oil production capacity is Saudi Arabia, which is at risk of its own civil uprising. The longer the Middle East continues its civil unrest; nearly 35% of the world’s oil production will inevitably be disrupted.
According to an energy analyst at Nomura, the price of a barrel of oil will exceed $220, if Saudi Arabia has to produce another 3 million barrels of oil a day. Most analysts believe the demand for energy from emerging markets like China, Brazil and India will not allow any let up in aggregate demand for oil. As a result, any supply shock will cause immediate price increases around the world over night. The International Energy Agency stated last week that the demand for oil has increased this year alone by 1.7 million barrels per day, which has caused nearly every oil producing nation to operate at full capacity. The risk is not that Libya has closed some of its ports, which is responsible for 3% of the world’s oil production; it is the risk of other nations in the Middle East doing the same.
In the United States, the economic picture was somewhat positive this week with consumer confidence reaching 70.7, the highest reading since the financial crisis began in 2008. The jobs component of the report was improved and fewer consumers expressed difficulty finding jobs. Moreover, consumers in the survey expressed interest in future buying plans for big ticket items like cars and appliances. On the housing front, existing home sales improved by 2.7% month over month with an annual improvement of 5.2%. Nevertheless, the median home price fell 5.9% this month to $158,000 and the average home price fell again by 5.1% to $206,700. Clearly most of the improvement in home buying is a direct result of lower overall prices. In addition, new homes sales contracted once again last month by 12.8% resulting in the supply of homes for sale to 7.9 months of excess inventory.
According to one of my favorite market strategist David Rosenberg, the main headwinds for the next 4-6 months for the equity markets are the following:
1. Declining Home Prices
2. Contracting Bank Credit
3. Listless Jobs Market
4. Soaring Oil Prices
5. Accelerating Spending Cuts (1936-37 all over again!!!!)
6. Policy tightening overseas (This will affect domestic demand and the US export picture)
Currently, the US government is poised again for another government shutdown (i.e. 1995-96) next week. Congress is currently arguing over $100 billion in spending cuts in the next fiscal year, which frankly is nothing considering we are projected to run up another $1.65 trillion in debt in the fiscal year 2011. The Democrats do not favor spending cuts, and believe any cuts will derail the current economic recovery. Conversely, the Republicans believe they have a mandate due to the results of the election last year to cut spending. Whatever the case may be, the current national debt will easily exceed $16.5 trillion at the next fiscal year, in which congress has to approve to lift the debt ceiling before March 4th. The Republicans have vowed they will not approve any debt ceiling increases that do not include substantial government spending cuts.
Our investment strategy remains steadfast. We believe the doubling of equities over the last two years have more than rewarded investors for assuming risk. Due to the tension in the Middle East, the oil markets are going to be extremely volatile over the next several months. The risk of a US Federal government shutdown in the coming weeks and months will undoubtedly cause the equity markets to over react in either direction. However, probably the biggest drag on the economy will come at the expenses of the massive state and local government spending cuts that will take place in the next fiscal quarter starting in April. We believe it is prudent to take some profits and move to a modestly defensive strategy, while capitalizing on the possible oil spikes in the near term. The VIX, which measures investors’ fear, jumped nearly 25% last week after being dormant for the past several months. Investors are taking profits and adding protection to their portfolios. We believe the risks are too high to embrace an aggressive portfolio management strategy, until the geopolitical and domestic changes are more clearly defined.
