After a two-month spring reprieve from a brutal 2008 start, markets again turned choppy. Defensive investors are contemplating potential summer surprises for the global capital markets. Commodity exporters such as Canada, Australia, Brazil, Russia and the OPEC nations continue their strong economic spurt as rising commodity prices make their oil and mining resources ever more valuable. China and India are fueling their growth with the duel engines of: a) consumer and service exports; and b) strong internal demand. Much of the global question mark falls on the US and Europe whose banks and governments now bear the pain of a Western mortgage and credit crisis; over $350 billion in bank write downs to date.
Oil’s jump to above $130 a barrel may have come as traders were forced to correct bad bets that the price would drop. The rush to buy back contracts may be due to smaller speculators that had taken short (negative) bets on oil contracts. Long run, oil should trade between $70 and $120 per barrel. Oil supply in April exceeded average monthly demand; Nigeria and Iraq are overcoming saboteurs and increasing production and Saudi Arabia will also pump more. Non-OPEC countries Norway, Britain and Mexico are seeing less production, but Brazil, Azerbaijan, Sudan and the U.S. are delivering increases.
Global growth will slow despite a better tone in markets and data over the beginning of the year. Given the oil shock, the Fed is right to hold rates but monitor inflation expectations. None-the-less, the dollar continues to suffer from the perceived lack of inflation-fighting credentials at the Fed. In Europe, sustained higher oil prices could lead to inflation fighting rate hikes and a hard landing. The risk of persistent high inflation is taking over as the dominant market theme. This should limit further increases in risk appetite. As inflation concerns take center stage, expect them to affect policy most in the euro area, while the Fed should remain on hold for a while.
Although US housing prices have not found a bottom and food and gasoline prices have not found a top, the hope is that jobs (buoyed by strong exports) will stay strong and the US will not enter a deep recession. Congress’s Dodd-Shelby bill will be neutral in the short term for mortgage securities and marginally positive in the long term. Macro-economic cracks have appeared in the form of the Fed’s hawkish commentary and stubbornly high oil and commodity prices which, if sustained, may translate into more fundamental credit weakness. The Fed’s quick lowering of interest rates and strong export growth helped by a weak dollar may keep things humming in the face of a sour housing market and tightened credit standards. None-the-less, US business bankruptcy filings increased 50% from a year ago as the sluggish economy prompted more companies to close.
The ability to lift prices is critical to supporting earnings in an environment of narrowing overall profit margins. Globally exposed industries are winning the pricing power battle. Exposure to brighter economic prospects outside the U.S. (i.e., emerging markets) and a soft dollar should make it easier for globally exposed groups to lift selling prices and gain market share from competitors struggling with strong currencies. In contrast, domestic-focused industries must contend with sub-par domestic economic growth, and in particular, the ongoing consumer retrenchment. The global theme is well entrenched, and has further to run.
Michael Ashley Schulman, CFA
Hollencrest Capital Management