One Fly in the Ointment Remained

When the markets were falling apart earlier in the year we retained our 'cautious optimism' position on equities because we felt that the Fed was both willing and able to stem the downwards spiral of confidence in the banking sector. The Fed's decisive action in March regarding the bail out of Bear Stearns certainly seemed to do the trick. Markets rebounded, bond yields went up and the dollar stabilised. All of this was in line with our expectations. However, one fly in the ointment remained.

In the twelve months to March the euro and crude oil had correlated 92%. We had therefore expected a dollar recovery to precipitate a correction in commodity prices. In the event oil did not correct, rather it continued to trend higher as its prior correlation with the dollar broke down. This proved disastrous for the markets for two reasons: first, it was yet another body-blow for cash-strapped consumers and second, it fed inflation fears and pushed interest rates higher. Nowhere was this more apparent than in Europe, where the ECB surprised everyone in early June by announcing their intention to hike interest rates despite the slowing economy.

The impact of the ECB announcement on the markets was dramatic. The dollar weakened as the bond market priced in not one but several rate hikes. The uptrend in the oil price accelerated upwards, leaping $14 in just two days. Investor sentiment crumbled as talk of a 70's-style stagflation (low growth combined with high inflation) became common-place. Finding themselves stuck between a rock (higher bond yields and interest rates) and a hard place (rising energy costs), equity markets headed lower still.

We hedged part of our equity position in late May, anticipating some form of short-term correction. However, we closed them in mid-June believing that the markets would soon turn higher. That view was clearly wrong in the short-term and many markets have subsequently moved to new lows for the year. Our over weight position in Asia has been particularly painful, with markets like India being hit hard by inflation concerns.

Looking ahead, it is hard to see the markets rallying without a meaningful correction in the oil price. As we discuss in the July edition of Perspective, we don't expect high energy prices to translate into a 70's-style inflation crisis. Nonetheless, the high oil price is a problem. Equities have always struggled to rally with oil price inflation at these levels. In addition, the way it is pressuring interest rates higher outside America is also a big problem for equities. Rising interest rates (and the consequent inversion in the yield curve) is particularly bad news for European financial companies already struggling to come to terms with the credit crunch. In addition, rising interest rates are also undermining the dollar and the weak dollar is helping to feed the commodity bull market.

The bottom line is that the global economy remains trapped in a vicious spiral (weak dollar, rising non-US interest rates and high commodity prices) which has resulted in this big drop in share prices. There is room for optimism however. If inflation is not a deep-seated problem, then there is no reason why equities should be substantially de-rated. Furthermore, it will mean that the authorities will ultimately be free to take remedial action to support economic growth. If that's the case, equities look cheap.

However, once again, we must return to the issue of oil. What will it take to get its price down? Ultimately the best cure for a high oil price is a high oil price. Confidence has already taken a big hit and consumers have started to change their habits. If all other things remain equal, demand will eventually sag, thereby dragging down the price of oil. However, by that stage markets could be somewhat lower than their current levels. The authorities could do more to encourage fuel conservation, but such policies would likely prove disastrous at the ballot box (although it is encouraging to see Asia scaling back its fuel subsidies).

It may be that the best hope for a lower oil price lies with a US dollar recovery. At some point higher interest rates will cause the global economy (ex-US) to slow dramatically. Providing US inflation does not take-off in the interim (our base case), the dollar will then turn higher, thereby removing an important prop for commodity prices. How close are we to that point? We could be very close. When the ECB increased interest rates by 0.25% to 4.25% it poured cold water on expectations for further such increases. European bonds rallied, the euro weakened and the oil rally was stopped in its tracks. If the economic news flow continues to deteriorate in Europe and the UK, it seems likely that we will see more of the same in the weeks ahead.

It could be as simple as this. The euro is currently stuck in a $1.53 to $1.58 range. If it breaks up, there will probably be more oil strength and equity volatility. If it breaks down, it may be the first sign that the markets are on the road to recovery.

Even if we're wrong and the demand destruction' scenario plays out, it seems likely that markets will soon experience a period of relief. Not only are markets becoming technically oversold', but also many have fallen to areas of solid support on the charts and sentiment is becoming sufficiently pessimistic to produce a bounce of some magnitude.

The bottom line is that we are retaining our current neutral/positive equity position. Although we don't rule out the possibility of further losses in the very short-term, we feel there is a reasonable chance that the benign scenario (dollar recovery, lower oil price, lower inflation) has merely been delayed rather than derailed. But even if that's not the case we suspect that we will get an opportunity to sell at higher levels in the months ahead. Geographically, US equities look the safest option, supported as they are by low interest rates and the undervalued dollar. However, if oil does correct, expect Asian markets and possibly Europe to rebound strongly.

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