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How should investors deal with an oil shock?

Oil prices have risen substantially in the past months. Given the ongoing unrest in the Middle East, a potential oil shock is still one of the biggest risks for economic growth and financial markets.

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In the past forty years we have seen five episodes in which oil prices skyrocketed. How did financial markets react in those periods and what lessons can we learn from them?

Firstly, higher oil prices tend to dampen global growth, as they trigger a transfer of income from net oil importers to net exporters. The latter usually have a lower inclination to spend the money. They are more likely to save it (through sovereign wealth funds) in order to create a buffer for a less oil-rich future.

Secondly, we should make a distinction between supply shocks (1973, 1980, 1990), in which oil supply is disrupted, and demand shocks (1999, 2007), in which demand for oil rises strongly. Supply shocks, which are usually caused by unrest in the Middle East, tend to be negative for financial markets. This does not need to be the case for demand shocks, since these usually go hand in hand with strong economic growth.

In the past, oil shocks were often followed by recessions, even if they did not necessarily cause them. But they did help to reinforce the negative effects of other issues, like the US saving and loans crisis in 1990, the collapse of the IT bubble in 2000 and the start of the credit crisis in 2008.

How did these events affect financial markets? Surprisingly, soaring oil prices did generally not hurt fixed income investors. The return on US and Eurozone government bonds has not been negative during any of the five periods mentioned. On average, the fear of slower economic growth in the long term outweighed the fears of higher energy inflation in the short term.

In the case of equities, the market reaction was different depending on the type of shock. Supply shocks tended to have a negative impact on equity returns, especially for cyclical stocks. Conversely, demand shocks did not have an adverse effect and were in general positive for cyclical stocks. The only investments to do well in both types of situation were energy stocks and commodities in general. Consumer stocks, like retail, luxury goods and automobile producers, usually suffered the most.

These days we are facing a situation in which the rise in oil prices can be mostly attributed to a rise in demand, especially by emerging markets. Also the rekindled discussion on the risks of nuclear power may help demand for energy sources like oil and natural gas in the longer term. Having said this, the recent demand shock could transform into a supply shock when the situation in the Middle East escalates. Saudi Arabia has a key position in this respect since it holds most of the OPEC excess capacity. This is also the country which used to compensate for regional production loss during previous oil shocks.

To conclude, we think that the recent rise in oil prices is mostly driven by rising demand and therefore not harmful for financial markets. However, the situation in the Middle East still poses the risk of a further, supply driven, jump in prices. In this scenario equity markets would be vulnerable, especially as the planned rate hikes by the ECB are likely to dampen growth prospects anyway. Fixed income markets would probably hold up better. In any outcome, oil prices should remain high, underlining our long held positive view on energy stocks.

Ad van Tiggelen , April 2011

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