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Equities: will oil spoil the party?

After the strong start to the year equity markets are getting vulnerable to profit taking. A further rise in oil prices could well provide the excuse for doing so, certainly as the momentum in liquidity creation seems to have peaked

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In February, oil prices rose around 10%. At the same time, global equity markets continued to rise, with oil sensitive cyclicals and financials leading the pack. Better than expected growth data and abundant liquidity creation clearly outweighed the negative impact of high oil prices. Can this continue?

Historically, equity markets have been able to cope quite well with rising oil prices, as long as the rise was gradual and driven by a growth in demand. After all, an increasing demand for oil generally coincides with satisfactory economic growth, a factor which offers compensation. However, whenever the rise in oil prices was steep (30%+ in three months) and/or driven by disruptions in supply, equity markets suffered a clear setback.

The current geopolitical risk premium in the oil price is less than 10 dollar, still insignificant in relation to the expected impact of any mishap in the region, which could easily boost prices by 30 dollar or more..
Ad van Tiggelen

In that sense the complacency of investors in February was unusual, as the rise in oil prices was quite significant and could not be fully explained by demand factors. In fact, other commodity prices hardly increased in this period. Therefore, part of the move in oil was probably due the growing tensions around Iran, which could lead to future disruptions in supply. Even so, the current geopolitical risk premium in the oil price is less than 10 dollar, still insignificant in relation to the expected impact of any mishap in the region, which could easily boost prices by 30 dollar or more.

The complacency last month was not only seen among investors, but also among consumers and companies. For example, the percentage increase in US consumer confidence outpaced even the rise of gasoline prices at the pump! The same positivism was visible in Germany.

The only sector which offers protection against this outcome is the energy sector, especially the oil majors..
Ad van Tiggelen

This behaviour can only be explained by the historically unprecedented stimulus provided by the major central banks in the world. Investors worry less about oil supply if they do not need to worry about liquidity supply. Besides this, the ongoing fiscal stimulus and surprisingly strong job creation in the US have clearly supported sentiment.

After the strong start to the year equity markets are getting vulnerable to profit taking. A further rise in oil prices could well provide the excuse for doing so, certainly as the momentum in liquidity creation seems to have peaked. It is important to realise that an oil driven correction would likely lead to a complete reversal in sector performance. The cyclical sectors, which have showed the strongest rise year to date, would suffer most. The defensive sectors, which have clearly lagged year to date, would hold up relatively well. The only sector which offers protection against this outcome is the energy sector, especially the oil majors.

To conclude, we do not see the recent rise in oil prices as an immediate threat to the sentiment in equity markets. The rise is not (yet) steep enough and supply fears are not (yet) big enough to outweigh the positive effects of liquidity creation, ultra low interest rates and generally decent economic activity. However, any continuation of the recent price trend should be seen as a risk factor, certainly as the momentum in liquidity creation has peaked and elections within the eurozone appear on the horizon.

Ad van Tiggelen , March 2012

Article also available in : English EN | français FR

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