The financial markets appear to be betting that the latest depressing news emanating from the Middle East is manageable and won’t escalate. The Oil
price has slipped back from the new nominal highs achieved a few days ago as slight hints of a rift in the Israeli cabinet combine with indications from the United Nations that it might be prepared, yet again, to step into the breach and to oversee order restored in what remains a profoundly turbulent region.
Threats to the global economy: rising price of oil
The principal risk to the global economy lies in a further escalation in the price of a barrel of oil. Notwithstanding the fact that Western Developed economies are less dependent on oil now than they were in the 1970’s and that in inflation-adjusted terms the oil price remains below the peak achieved at the time of the overthrow of the Shah of Iran in 1979. Speculative cash has poured into oil futures of late, driving the price of a barrel of light US crude to more than $78.00, thus masking the heightened risk of a “hard landing” for the global economy over the months ahead.
Investors should already be well aware of the other threats to the global supply of oil including ongoing unrest in Venezuela and further acts of sabotage in Nigeria. Meanwhile nature seems to have stayed her hand in the Gulf of Mexico through this hurricane season, however, as this article is being created those observers of severe weather in the region are beginning to cast a wary eye over a tropical low with rotating characteristics which has just been released westwards from North Africa. Although the hurricane season is in its early stages this year has already proved much quieter than last, a function, we are told, of cooler Atlantic water and upper air conditions less favourable to the creation of deep tropical lows. Long may prevailing conditions persist!
Threats to global economy: escalating geopolitical tensions
Despite the evaporation of part of the risk premium built in to the latest oil price spike, sufficient geo-political uncertainty exists to ensure that near-term downside looks pretty limited. Another shock, from whatever source, should be sufficient to drive the futures price over $80 per barrel and even $90 per barrel isn’t out of the question if something goes badly wrong. Investors should note, however, that as the chart shows, back in 2003 oil was trading at just £26 per barrel and that the global economy has managed to handle a $50 per barrel increase in just three years without too many serious side-effects so far!
As we commented in our “Echoes From The Past” Week In Preview note published on 5th August 2005 the key risk lies in an escalation of Middle Eastern conflict to the point where cross-border conflict on top of the World’s biggest oil resource drives the price of a barrel over $100. Despite the terrible human tragedy unfolding in the Mediterranean most will wearily shake their heads. We have been here many times before, most notably in the recent past in 1993 and 1996, with no wider long-term repercussions. Any conflict which drags Syria into the melting pot is much more manageable than one which drags in, say, Iran which can boast far greater military firepower and is a far more significant oil producer.
Threats to global economy: interest rate hikes
A further threat to the global economy lies in yet higher short-term interest rates. As has been pointed out in previous Weeks In Preview publications, the US has gone (is going) through its most aggressive period of monetary tightening in history. We are convinced that there will be a price to be paid by the real economy over the weeks and months ahead. Last week we looked at previous margin peaks and corporate earnings performance in the year following those peaks. It remains a remarkable feature of this “normal” economic cycle that most companies have managed to overcome continually higher raw material and energy costs, and despite failing to pass them on in full to customers at the factory gate have successfully boosted productivity and cut costs to ensure that profitability has held up. Quiescent labour markets have proved extremely helpful and to date, labour’s share of corporate profitability has fallen to new low levels. It remains to be seen whether this will change, however, the huge increase in the global workforce has been a massive and undeniable help thus far.
All that said, the developed market Central Banks are alert to the risk of higher inflation and have begun to act in unison to withdraw liquidity from the system.
By raising short rates in the context of an already flat or even inverted bond yield curve US authorities have raised eyebrows in some quarters. It is this, rather than an escalation in the oil price, that has driven financial markets increasingly to fear the outlook for growth over the outlook for inflation.
Threats to the global economy: the end may be In sight
Futures markets have responded very positively to Fed Chairman Ben Bernanke’s Humphrey Hawkins testimony. The probability of a further (possibly final) Fed Funds rate hike to 5.5% has fallen from 60%+ to 50%.
Key takeaways from the testimony include: inflation expectations have “edged down”. This is very good news for the Treasury market as it suggests that the battle (what battle?) against inflation is close to being won.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley
Recommended further reading:
If you would like to know more about what how current geopolitical tensions could affect the global economy, read what Lebanon means for the world economy. Also see Simon Nixon on why US borrowing – not oil – is the biggest problem facing the West and James Ferguson on the real reason for the oil price rise. For a full list of articles on interest rates, politics and more, see our section on economics.