Oil and stock-markets likely to delink this year

Analysts say rising fuel costs could dent corporate profit margins, driving the stock market down
Oil and stock-markets likely to delink this year
By Reuters
Thu 26 May 2011 01:12 PM

Oil and equities have been in lock-step for much of the last two years but this is likely to break down in 2011, as high fuel costs dent demand and chip away at confidence in global economic growth.

The ending of the second round of quantitative easing (QE2), that has pumped $600bn in financial markets since last year, will exacerbate the break, fund managers and analysts say, and could mean the asset classes start to move inversely.

"Once QE2 is out of the way, the wave of money that has flowed into commodities will recede and the high correlations between commodities and other asset groups will diminish," said Nicholas Denbow, fund manager at VOC Capital Management.

Share moves have tended to track the sharp swings in oil prices since the last global financial crisis, which saw assets perceived as risky first of all dive, and then recover sharply.

In the five years running up to the crisis, oil and stock markets regularly moved inversely as higher oil prices were generally seen as damaging the prospects of companies that would face higher costs.

But government attempts to avoid a long and deep recession - a massive injection of cash into the economy and easy monetary policy - have encouraged investors to treat commodities such as oil as just another asset class.

This saw investors pile in to crude when the economic outlook looked brighter and flee when data looked bad or geopolitical or corporate news flow knocked sentiment.

But as QE2 ends, the close relationships it fostered are likely to break down.

Oil prices have now got so high that they are forcing consumers to rethink their use of fuel and eating into profits, a move that analysts expect to impact equities valuations.

"There's a thought from equity investors that's consistently bubbling up that oil is moving to levels that will hurt growth," John Haynes, head of research at Rensburg Sheppards.

Research by Empirical Research Partners shows that if US consumers' outlay on energy rises much beyond 6 percent, it starts to impact their general level of spending, and that level has now been breached.

"[High] oil ... has a negative impact on other bits of the economy, so the correlation could turn around, so when oil prices go up, equity prices go down," Haynes said.

There are already signs oil prices - about 40 percent above their levels at the same time last year - are sapping demand.

"When we look at the latest data from the US department of energy, US oil demand is down 1.1 million barrels per day," said Olivier Jakob, head of energy consultants Petromatrix.

"It has fallen back to the levels of 2009 at the same time of the year. We've lost in the United States as much oil demand as the supply we have lost from Libya."

The impact will feed through this year.

"I think for the US we will have 1 percent slower GDP growth than we would have had if oil had stayed at $80 per barrel for 2011, and that is also bearish news for equities," James D Hamilton, professor of economics at University of California in San Diego.

Oil, gas and other energy companies make up a high proportion of the leading stock market indexes, representing 11 percent of the MSCI All Country World Index and 19 percent of the FTSE 100, and this, paradoxically, is also likely to put pressure on the oil-equities correlation.

"Given that the financial sector is so weak you have to have the other sectors compensate for it to be able to reach those peaks. If you look at the target to reach 1,450 on the S&P you need oil to go to $140 per barrel," Jakob said.

"You're putting the real economy at risk [if you] achieve those levels on the S&P while the financial sector is so weak."

The impact on the real economy from high oil prices will soon start to show, and stocks, which often act as a leading indicator, will be vulnerable to oil price strength.

"Rising commodity prices equals inflation, which becomes wage inflation, which dents corporate profit margins, which sends the stock market down," said Charles Morris, manager of the $2.5bn HSBC Wealth Opportunities fund.

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