A look at the History of the complex relationship between rising oil prices and global bear markets points to some surprising conclusions
When the oil price was below $25 three years ago, I predicted in this column a new secular trend in the market for oil, protecting prices in slumps and boosting them in booms. Then my suggestion was that this factor could also have significance for other raw materials and lead to a general bull market in resources shares all round the world. Now that oil prices are twice as high, the question is will it lead to a global bear market, as it acts as a tax on the developed world?
The history lesson below leads to a surprising conclusion.
Graph 1 (below) shows the relationship between share prices and both nominal and real oil prices adjusted for inflation. As one can see, it is complex.
Cycle One: 1972-78
For decades until the early 1970s the price of oil, like exchange rates, was effectively fixed in dollars. However, from cycle to cycle inflationary pressures increased as governments stepped on the economic accelerator each time there was a recession but braked modestly when there was a boom, hoping to buy votes each election time with increases in consumer incomes.
The first warning sign of global inflationary pressures was the devaluation of sterling in October 1967, when the game was up in the UK. The US survived one more cycle, before the dollar too was devalued in February 1973. In June, the Nixon Administration imposed price controls in an attempt to hold the lid on the inflationary pressure cooker.
On 6 October of that year, Egyptian and Syrian forces launched a surprise attack on Israel. Against the numerical odds, with the help of US technology, Israel effectively won the war by 15 October. In retaliation, the Arabs allies used their control of OPEC to quadruple oil prices and impose an embargo on the US.
A modest correction was underway but was rapidly transformed into the most viscous recession and bear market since the Great Depression of the 1930s. From peak to trough, share prices fell by 33% in Germany, 46% in the US, 48% in Japan and a massive 70% in the UK by the end of 1974.
While the oil price rose a further 50% in the next three years, this was merely to keep the real price stable by matching the rate of inflation. During that time, share prices rose substantially, recovering most of the losses experienced in the bear market.
Cycle Two: 1979-86
By 1978 another economic boom was underway. In the three years from 1976 to 1978, global GDP grew more than 4% compound annually, leading to capacity constraints and generally rising commodity prices.
In April 1979, the Shah of Iran was deposed, depriving the US of its strongest ally in OPEC. Within a year, the cartel increased the price of oil from $15.85 to $39.00 per barrel. Share prices continued rising moderately for a few more months but at the beginning of 1981 a bear market set in which saw an average 20% fall in global share prices.
In this cycle the roles were reversed, with the real world suffering rather worse that the financial world. Buffeted once by the oil crisis and a second time by record-high interest rates to kill off inflation, the US suffered the worst with a double dip recession between 1980 and 1982. The all-time peak of oil prices in June 1980 was succeeded by an all-time peak in interest rates in August 1981.
As stock markets worldwide embarked on the beginning of the two decade-long disinflation bull market, oil prices slumped. Within four years, share prices had risen by 150%, while the oil price slumped to a low of $12.
Cycle Three 1986-94
Eventually, the record-high prices of 1980 proved counter-productive. Substitution, an improvement in technology in both enhanced extraction and fuel-efficient use, as well as increased exploration in higher-cost non-OPEC regions all combined to create a better balance between demand and supply, in which environment rising GDP, oil and share prices all moved together through most of the cycle.
However, this pattern was disrupted by one important exception - the invasion of Kuwait by Iraq in August 1990. Once again this politically-inspired supply disruption took place at a time of buoyant economic activity, as the oil price soared from $16 to $35 per barrel within three months, before collapsing again once Iraq was driven out.
Cycle Four: 1994-98
Here again GDP, oil and share prices all fluctuated together. The distinctive feature of this cycle was that share prices fluctuated around a rising trend, while oil prices fluctuated around a falling trend.
The relative weakness of oil prices was largely attributable to the series of emerging market crises which started with Thailand in June 1997, spreading rapidly across Asia and eventually engulfing Russia as well in October 1998. For the first time ever, the disproportionate influence of emerging markets on the oil price was brought into sharp focus.
In my earlier report on this issue, I wrote "Whereas a Briton upgrading from a Peugeot to a Porsche will consume few more raw materials, a Malaysian buying their first Proton will consume substantially more aluminium, copper, glass, plastic and steel, all of which in turn require substantial energy input."
Cycle Five: 1999-2001
Once again, GDP, oil and share prices all fluctuated together. However, this time the relative strength was reversed. Shares had an especially bad bear market as the Millennium bubble collapsed, ending substantially lower on balance, while the oil market had a strong bull market, with the price rising from the all-time low of $11 to a cyclical peak of $34 per barrel as the global economy boomed, before falling back to $19.
While this cycle did not end in a recession as the four previous cycles did, there was nevertheless a worldwide slowdown as GDP growth rates sank close to zero in the advanced economies.
Cycle Six: 2002-
In the current cycle, oil and share prices have parted company. Shares have retreated further as various corporate scandals lead investors to reassess the meaning of reported profits. On the other hand, oil prices have advanced as economies around the world have recovered.
From this historical review it should become immediately apparent that the subject is a great deal more complex than oil price up, share prices down. To arrive at a meaningful prediction, it is necessary to separate out several strands.
According to economic theory, higher oil prices are themselves a response to strengthening economic activity, which stock markets generally anticipate by a year or so. Higher oil prices should therefore respond, with a lag of a year, in the same direction as share prices, as do other commodity prices. Since a lagging indicator cannot predict a leading indicator, oil prices should be useless as a predictor of share prices.
However, higher oil prices are a tax on consumers in both the developed and developing worlds, because the major producing countries are, on the whole, not significant in global stock market indices. When combined, the only net exporters - Canada, Indonesia, Norway, Mexico and Russia - account for less than 4% of the FTSE World index. Higher oil prices therefore act to raise inflation and/or reduce demand in the rest of the world, so stock markets and oil prices should move in opposite directions.
Politically-inspired disruptions in producing countries have a nasty habit of occurring when demand is already high. Possibly the timing of the Yom Kippur war, the fall of the Shah of Iran and the invasion of Kuwait were more than coincidental. These events aggravated the inverse relationship in three of the five cycles. Unfortunately, economists are unable to forecast such surprises.
As a cartel, OPEC is only really effective when there is a political reason to combine. Only the increases after the Yom Kippur War and the fall of the Shah of Iran proved durable. At all other occasions cheating emerges, so the price depends on a swing producer with spare capacity, and that is Saudi Arabia. Therefore, the cartel effect really only applied in two of the five cycles.
It is economic activity in the developing world, rather than the developed world, which nowadays proves to be decisive, because of their generally disproportionate influence on resources, as mentioned earlier.
When the oil price was $25 in 2002, the consensus among economists was for Asia, as the world's industrial powerhouse, to grow by 2.2% in the forthcoming year, while generating inflation of only 0.4%. Now, three years later, after the oil price has doubled, the consensus is for even higher growth at 3.3%, while inflation remains a still modest 1.3% in this region.
Since the situation is similar, what is to prevent the oil price rising by another $25 per barrel before adverse economic reactions become a serious concern? If there is little reason to expect an economic downturn on these grounds, then there should be little reason for the stock market to fall in anticipation. There may be other causes for concern but oil does not appear to be one of them.
The general consensus is that rising oil prices are bad for share prices but, fortunately, economists are predicting falling oil prices. According to Consensus Forecasts, the average expectation is that prices will fall from a spot rate of $46.80 as at mid-February to $42 by May and only $39 by February next year. Unfortunately, they have been predicting a downturn since the price breached $30 two years ago, so they have been consistently wrong. Indeed they have just become even more wrong, as the price of oil soared almost $10 in the last month.
If a $25 increase in oil prices is not sufficient to turn economists negative on Asian GDP, perhaps another $25 increase needs to take place before we all need to worry about an oil-induced recession.
Paul Bruns and Elaine Parkes
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