Global stocks and bonds have performed
exceptionally well since 2003 despite the
relentless rise of international crude oil prices.
The apparent containment of US inflation has
strongly supported global stock and bond
performance over this period as have overly
optimistic assumptions that international crude
oil prices will decline in the future.
The
continued rise of international crude oil prices
and the growing risk of fuel shortages in the
months ahead will push US and global inflation and
interest rates sharply higher and global economic
growth and asset values much
lower.
Join the party Between
January 2003 and September 2005 the US S&P 500
stock market index advanced by 34%. Over the same
period leading stock market indices in Germany,
Japan, Korea and Brazil have gained 62%, 48%, 74%
and 127%, respectively. Similarly strong stock
market performance has occurred in many other
countries.
In addition to strong stock
market performance, bond markets worldwide have
also performed exceptionally well since 2003
supported by declining long-term interest rates.
Perhaps most indicative of this strong performance
has been the collapse in aggregate emerging market
bond spreads from about 900 basis points over US
Treasury Bonds at the beginning of 2003 to
historical lows of under 300 basis points in
September 2005.
Oddly, this period of
sharp gains in global asset values has been
accompanied by equally strong gains in
international oil prices. In 2003 and 2004, the
annual average price of US benchmark WTI crude oil
advanced by 19% and 32%, respectively. In the
first three quarters of 2005, the price of WTI
crude oil increased by a further 30%.
The
weakening linkage between global stock market
performance and steeply rising international crude
oil prices has been mirrored by the weakening
linkage between crude oil prices and global demand
for crude oil. According to the US Energy
Information Administration (EIA) the average
growth of global crude oil demand was about 1.4%
in 2003 and 2.6% in 2004.
In the first
three quarters of 2005, global crude oil demand
has continued to grow at a rate in excess of 2%.
By comparison, global demand for crude oil
increased at an average annual rate of about 1%
between 1991 and 2002. The sudden surge in global
crude oil demand has been led by China where crude
oil demand advanced by 5.6% in 2003 and 6.4% in
2004. Thus far in 2005, China crude oil demand
growth has remained well above 6%. Rather than
reducing global demand as economists would
normally expect, the leap in international crude
oil prices since 2003 has been accompanied by
exceptionally strong global demand growth by
historical standards.
Choose your
poison: Inflation or bankruptcy One of the
key factors that has supported global-asset
performance since 2003 has been the apparent
containment of US inflation despite surging crude
oil prices and accompanying steep gains in
derivative energy products such as gasoline,
natural gas and fuel oil. While crude oil prices
have increased by a cumulative 110% since the
beginning of 2003, gasoline, natural gas and fuel
oil prices in the US have advanced by 92%, 70% and
50%, respectively.
The US Federal Reserve抯
preferred inflation indicator, the personal
consumption expenditure (PCE) deflator, produced
in conjunction with US national accounts data,
advanced at a miserly rate of 1.9% in 2003,
increasing slightly to 2.6% in 2004. In the first
half of 2005 the PCE deflator rose at an
annualized rate of 2.9%.
The Fed's
preference for the PCE deflator stems from
consumption weighted nature of this price index.
In other words, goods in the PCE deflator are
weighted in proportion to how much Americans spend
on any particular class of consumer goods. This
allows changes in consumption patterns to be
immediately reflected in the PCE deflator and
apparent inflation.
Since 2003, the
primary consumer good that Americans have been
purchasing has been automobiles. Interest-free and
low-interest rate loans have spurred this
automobile sales boom. At the same time, intense
competition has forced auto prices lower. This is
reflected in the PCE deflator for consumer
durables, the most important component of the
overall PCE deflator, which declined by 3.5% in
2003, 1.9% in 2004 and by 1.7% in the first half
of 2005.
Without the steady decline of
automobile prices the PCE deflator would have been
much higher in 2003, 2004 and thus far in 2005.
Though overall inflation has been held in check by
falling automobile prices in the past three years,
almost every US automobile manufacturer, and
several important automobile parts suppliers, are
now teetering on bankruptcy.
Deluded
optimism Another important factor that has
supported the performance of global asset prices
since 2003 has been investors' overly optimistic
assumption that crude oil prices will decline in
the future. Obviously this assumption has not
panned out since 2003. Nonetheless, investors and
analysts continue to believe that relentlessly
rising crude oil prices will suddenly push global
crude oil demand lower, allowing crude oil prices
to decline in 2006. Such a decline is unlikely.
While many analysts and investors have
focused on how the US economy has become more
insulated from rising energy prices, few have
considered how little room there is for energy
conservation. Most Americans are forced to
continue driving cars to and from work as public
transportation infrastructure in quite limited in
the US. Meanwhile, the multi-year automobile
buying spree in the US has left Americans with an
enormous stock of gas-guzzling light pickup trucks
and SUVs.
Similar to the reduced fuel
efficiency in the US stock of automobiles, the
strong addition to the housing stock in the US
over the past several years has reduced overall
household energy efficiency. In simple terms, the
amount of energy conservation that Americans can
muster to counter rising energy prices is quite
limited as evidenced by the weakening linkage
between crude oil prices and crude oil demand.
A very similar situation exists in China,
which is the world's second-largest crude oil
consumer after the US. Rather than housing, China
has seen a boom in energy-inefficient factory
construction. Rapidly rising incomes in China and
super strong economic growth have also created new
fuel demand that is highly price inelastic. It
would take a strong deceleration in US economic
growth to slow China's economy sufficiently to
moderate the country's crude oil demand.
In addition to these factors that are
underpinning global crude oil demand, the supply
of crude oil is constrained and is more likely to
decline than increase in the months ahead. OPEC
oil production is running at full capacity while
several important non-OPEC oil producers are
suffering from declining oil production.
A
burgeoning and potentially very powerful new oil
cartel comprising Venezuela, Russia and Iran, all
of which oppose US foreign policy, could use
reduced oil production as a weapon to tame US
military ventures. Finally the probability of
continued oil production shocks such as those
resulting from hurricanes in the US, sabotage in
Ecuador and strikes in Nigeria is very high. Given
the long lead time necessary for new oil
production to come on-line, an appreciable
increase in global oil supply is improbable in the
medium-term.
That's not daylight
An inflation shock in the US is very close
at hand. Much higher than expected US inflation
will have a dramatic negative impact on global
asset values and investors are ill-prepared for
this decline. The most overlooked factor that will
push US inflation much higher in the remaining
months of 2005 and into 2006 is the impact of the
recent hurricanes on US oil-refining and
natural-gas production capacity.
The
hurricanes that hit the US gulf coast have
shuttered over 5% of America's oil-refining
capacity. A similar amount of natural-gas
production capacity has also been shut down. It
will take many months for this capacity to come
back online. Spare refining and natural-gas
production capacity in the US is non-existent.
This means that prices for refined oil products
and natural gas are set to rocket higher as the
North American winter settles in.
According to forecasts released by the US
Department of Energy (DOE) this week, winter
heating bills for most Americans will rise between
32% and 48% in comparison to last year's heating
bills. This is probably an underestimation of how
steeply prices will rise, especially if colder
than normal weather prevails in the US this
winter.
In addition to the jump in home
heating bills, a similar increase in power bills
for American households is likely as 20% of
electricity generation in the US is produced by
thermal power plants fueled by natural gas and
oil. Finally, and most importantly, the reduction
of oil-refining capacity caused by the hurricanes
will create gasoline shortages in America, pushing
prices much higher.
It's no coincidence
that President Bush's recent appeal for Americans
to conserve gasoline is only the second time such
an request has been made. The first came from
president Jimmy Carter during the Arab oil embargo
in the 1970s presaging US inflation in excess of
10%.
The impact of much higher energy
prices on the PCE deflator is likely to be
profound in the next several months. Higher
gasoline prices will lead to a collapse in US
automobile sales. This will significantly reduce
the weighting of automobile purchases in the PCE
deflator and the impact of automobile price
deflation on overall US inflation. Concurrently,
rising energy costs will increase the weight of
energy products in the PCE deflator also pushing
overall inflation higher.
Prices for most
other consumer goods are very likely to spike
higher as much higher energy prices increase
production and transportation costs. Sound like a
doomsday scenario? Perhaps these very issues
underlie the Fed's growing concern with
inflationary pressures and its inclination to
continue pushing US short-term interest rates
higher.
Global asset values have advanced
strongly in the past three years. The risk of a
spectacular decline in global asset values in the
next 12 months, led by rapidly rising US inflation
and much slower than expected US economic growth,
is high. Investors should strongly consider
hedging their portfolios and reducing their
exposure to equities and bonds worldwide. The
light at the end of the tunnel is the inflation
freight train. Are you in the way?
Jephraim P Gundzik is president
of Condor Advisers, Inc.Condor Advisersprovides country risk analysis to individuals
and institutions globally.
(Copyright
2005 Asia Times Online Ltd. All rights reserved.
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