Most of the bears were waiting for hurricane Katrina to validate their pessimism. It arrived and despite public protestations of sympathy for the victims of the hurricane, they were grateful for the fact that fate had dealt them a great hand. However, it soon turned into frustration. Global stock markets rallied. The world rushed energy supplies to the US. Some refineries re-opened.
The buoyant reaction of financial markets to hurricane Katrina has seen the resurgence of the old chorus that there is extreme complacency in financial markets. That does not sound right. Investors are jittery; financial market commentary is negative and corporate executives are cautious. As Goldman Sachs puts it, the fixed income market has been prone to seeing economic weakness around every corner and bond yields are too low. Therefore, it cannot be true that risk appetite is strong.
Nonetheless, for congenital bears, it seems easier to accept that financial asset prices are bubbly and oil prices are not. What equilibrium model of oil prices tells us that oil at $65 is cheap and that $80 or $100 is a fair price? After all, the current price of oil is 160% above its 10-year average, while OECD demand is in line with the 10-year average and non-OECD demand is just about 15% above its 10-year average. Further, the current level of oil price is more than three standard deviations above its five-year average. Industry observers point out that crude oil speculators have been betting for the past year precisely on a weather-related event such as Katrina. Now that it has occurred, it might be reasonable for them to unwind their bets.
For the sake of argument, let us accept that a high oil price is here to stay. Nonetheless, oil is an input. Hence, its price is a cost to users. If there are other compensations, then the rising price of oil may not hurt so much as past experience would suggest. Globalisation of manufacturing and services has introduced tremendous competition. Cons-equently, labour costs in the developed world are growing rather tamely. Globali-sation and the emergence of communist China have helped corporate profits (even non-financial) in the US to keep growing at impressive rates, even as it has caused the conventionally measured external deficit to explode in the US.
However, globalisation of production of good and services must have hurt workers. That is not what one finds in the consumption habits of the American household. It is not due to growth in worker compensation, as a lot of it is due to indirect benefits. There are other factors. First, it was the tax cut, then it was the recovery in equities markets in the US and finally, the boom in housing prices has sustained consumption at high levels and driven consumption share of GDP to all-time highs. Is it in a big danger of falling off the cliff immediately?
The trigger that is supposed to cause this housing correction in the US is the risk that foreign central banks, particularly China?s, abruptly stop buying US treasury bills. It is far easier to say that China would not keep purchasing US treasuries than to prove why it should stop doing so any time in the near future. Indeed, there are enough indications that their dependence on the US consumer has increased, rather than lessened, over the years. China?s export share of GDP has gone up. Even if one were to exclude re-exports, the export share of GDP is much higher than it was in 2000. Consumption share of GDP has slumped and this is despite the fact that China has subsidised petroleum prices, taxi fares and public transportation fares and put a lid on refining margins. And despite a property price boom in some cities.
Given this, it is not hard to imagine what would happen if the price of crude oil were to remain high. China would be hard-pressed to maintain its subsidies. International pressure on the country to allow prices to be passed on would increase, as it would eventually help to restrain demand and help to bring down prices for the rest of the world, too. When China does so, it should not be hard to guess the prospects for any improvement in domestic consumption there. China would then compete more aggressively for export share and given its limitless and relatively costless labour, it would win the battle and recycle the resulting earnings into the US.
The developed world would have won a far bigger ?tax cut? bonanza from collapsing import prices than they suffered from the ?tax hike? of a higher oil price. Collapsing import prices would reinforce the ever-present disinflation tendencies in the US and elsewhere in the developed world. Bond yields would be significantly lower. If that happens, there would be no real pressure on US home prices and we will have come back a full circle.
Indeed, the relentless surge in crude oil has only pushed back the story of BRICs in general. Of course, it appears to be helping Russia in the short-term, but that it might eventually come to hurt the country. That is a different story for a different occasion and audience. The pessimistic case for emerging markets and China, in particular, might incidentally well serve the strategic goals of the world?s only superpower, even if it were a short-term cyclical economic nuisance. The above analysis shows that for the US, the surge in crude oil might well be a bonanza rather than a nuisance.
Hence, those looking for oil prices to remain high and/or head higher, and the American economy to buckle under its weight, are simply barking up the wrong tree. They would profit themselves and their clients by training their sights on more appropriately vulnerable candidates in the emerging world and in Asia, in particular.
The writer is the founder-director of Libran Asset Management (Pte) Ltd, Singapore. These are his personal views