Today’s oil trouble is changing the rules of investment
07 July 2008
The last global oil crisis in the 1970s had a devastating effect on the world economy, unleashing a bout of stagflation that had central banks, governments, and investment markets scratching their heads for a solution for the best part of a decade.
Global investment markets now appear poised at a similar point in history. Although the fundamentals are different – 1970s OPEC supply constraint versus 2008 global energy demand – the prospect of high inflation going hand in glove with a global recession cannot be ignored.
For investment markets, the ill winds have blown from unlikely quarters. Who would have envisaged that a group of low-income earners from the poorer parts of the US would default on their mortgages, eventually leading to a cascading, worldwide credit crisis?
The days of cheap oil are said to be over. Up to about five years ago, oil had been $20-$25 a barrel for 100 years (in 2007 US dollar terms). It’s risen 500 per cent in the past five years (it was about $25 a barrel at September 11, 2001).
How we adjust to a new world of high oil prices will ultimately be up to the market, which, inevitably, will weed out the losers and nurture the winners.
It is early days, but a picture is starting to emerge of what asset sectors should be avoided, or at least put on an underperforming list, and those that will present opportunities to investors.
Driven by commodity prices such as oil and food, loose monetary policy in the US, and the shift from exporting inflation to importing it from emerging economies, such as China and India, some of the inflationary effects on companies and earnings will soon become apparent.
In times of high inflation, we can expect an increased risk of earning downgrades, a downward re-rating of price/earnings ratios and a sluggish industrial sector – and their share prices valued accordingly.
The problems may be compounded by central bank policy of rising interest rates to fight inflation and an underperforming housing prices, most alarmingly in the major economies of the US and UK.
Such a slump in the primary asset of most of the population hurts consumer confidence; there’s the knock-on effect to the all-important construction industry; and, obviously, to the balance sheets of the banks and other lending institutions.
There is also a fundamental shift in global economic (and political) power – to the oil-producing countries from the oil-consuming ones.
So, in considering these macro effects, what shifts should be made within an asset allocation?
The changing global economic scene has reduced the importance of diversification as a risk management tool in asset classes such as equities and between asset classes such as property and equities.
Moves should be made towards high conviction managers and alternative strategies, such as long-short equities. Holding the market may mean diversification will cause a net exposure to the macro factors. The result is a portfolio that will be buffeted by the global economy.
Also, commercial property and infrastructure may not be the traditional hedge against inflation as it has been in the past because of uncertainty in credit markets. It is still not clear what the effect will be on these markets in light of tightening credit.
So, where to increase allocations?
Investors should look towards increased allocation for assets with very low correlation to the equity market and expected to outperform cash - gold; commodities; and alternative strategies, such as long-short strategies for credit, foreign exchange or equities.
Alternative asset classes and strategy exposure should be increased in the following:
- Fund of fund hedge funds: High conviction fund of fund managers as too much diversification may diversify away the specific risk and leave the portfolio exposed to the aforementioned macro factors;
- Commodity funds: A good way to gain direct exposure to the inflation in energy prices such as oil as well as agriculture, industrial and precious metals as well as very low correlation to equity markets
Finally, it’s worth quoting the Sage of Omaha, Warren Buffett, who was asked recently what he thought of the oil crisis.
Well, he said, although I wished I had bought more oil stocks years ago, it was worth noting that rail companies get a competitive advantage over trucking from high energy costs.
All aboard, anyone, for a train-led recovery? Tim Fischer will be pleased.
