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The Headwind of Oil

03/19/2012

Global risk assets continue to steadily appreciate, reflecting the continued modest improvements in U.S. macro data and the significant easing in European government bond yields. Against the improving global backdrop, oil prices continue to push higher, supporting our expectation for 2012 that oil is “Headwind #1” for all risk assets.
 
Year to date, domestic WTI oil (Figure 1.1) has risen from $99.65 to $107.06, or 8.32%. The global oil benchmark, Brent crude oil (Figure 1.2), has risen from $107.38 to $125.81, or 17.16%. More importantly, oil’s by-product, reformulated gasoline (Figure 1.3), has risen 24.96%, placing smiles on the CEOs of refiner corporations and shareholders. Despite the rise in oil and gasoline, the S&P 500® Index (SPX) (Figure 1.4) closed at its highest level since May 2008.
 
Should oil prices continue to uncomfortably rise, investors will need to address the significant possibility that rising oil will arrest the appreciation of risk assets and foster a sustained correction. To date, that has not occurred. For now, what is most important for investors is knowing “what to look for” as the warning signals for a correction. Here are the simplest, but I expect the easiest, conditions that will telegraph a correction from rising oil.
 
Let’s focus on three conditions:
 
1.  The relationship in performance between oil futures and energy equities (Figure 1.5)
 
Historical data suggests a divergence in the performance of oil futures and energy equities is a leading indicator for a shift in the equities market trend.
 
Back in early 2009, a buying opportunity in equities was telegraphed by oil futures that troughed in January and found support in February even as global equities continued to melt down.
 
In the spring of 2008, the XLE peaked in May, but oil futures continued to rise into July, telegraphing a meltdown in risk assets.
 
Currently, for the month of March 2012, the XLE (-.11%) has modestly underperformed, the price of Brent crude oil (+2.6%) is not flashing a significant warning sign yet but is worth monitoring. 
 
2.  U.S. Private Sector Jobs (Figure 1.6)
 
The trend in private sector jobs is relevant in terms of measuring the ability of risk assets to absorb a rise in energy costs on both the consumer and enterprise level. I would expect to hear in April from multiple CEOs about their concerns for rising input costs from higher energy in the upcoming quarters.  
 
Currently, private sector jobs continue to trend positively. Over the past three months, private sector jobs have grown 234,000, 285,000, and 233,000, providing a tailwind for risk assets and consumers to absorb the rising price of oil.
 
Back in 2011, during both Q1 and Q2, oil futures remained elevated above $100. In a classic example of “what to watch for,” private sector jobs printed 257,000 in February 2011, 261,000 in March 2011, 264,000 in April 2011, but OOPS! Only 108,000 in May 2011. That was the game changer for the trend in risk assets in 2011. Investors currently need to be on the watch for a similar scenario.
 
Also to keep in mind – the trend in private sector jobs in 2012 is completely different from 2008 when a significant contraction in private sector jobs was evident already in Q1 2008, not allowing consumers the ability to absorb rising oil.   
               
3.  Monetary policy in emerging economies, using China as the proxy (Figure 1.7)
 
Investors need to monitor monetary policy in emerging economies, which, as evidenced in the spring of 2011, are highly sensitive to rising energy. Back in 2011 and 2008, China was in the midst of a tightening cycle that needed to continue as CPI trended higher. Currently, CPI is trending lower and the central bank is focused on a monetary easing position. Any reversal in policy driven by rising CPI would be problematic. 
               
FINALLY...
 
Bears can grasp onto this month’s divergence between the XLE & oil futures as raising the red flag for an equities peak. Possibly, it is the catalyst for a much needed market correction. However, I expect that without other forms of deterioration (U.S. Jobs & EM inflation), it would be shallow in nature.
 
The prevailing bullish trend in risk assets will only be reversed if further proof were presented in the form of a private sector jobs contraction or a jump in CPI. The evidence for that is currently not present.
 
Figure 1.1 Spot WTI, Year to Date

Source: Bloomberg
 
Figure 1.2 Spot Brent Crude Oil, Year to Date

Source: Bloomberg
 
Figure 1.3 Reformulated Gasoline Oil, Year to Date

Source: Bloomberg
 
Figure 1.4 S&P 500 Index, April 2008 to Present

Source: Bloomberg
 
Figure 1.5 Relationship Between Oil Futures and Equities – 2009 and 2008 Scenarios

2009 Scenario


Source: Bloomberg
 
2008 Scenario


Source: Bloomberg
 
Figure 1.6 Oil Futures versus Private Sector Jobs – 2012, 2011, and 2008 Scenarios


Source: Bloomberg
 
Figure 1.7 China CPI

Source: Bloomberg

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