Second Quarter 2008 Market Report
Friday, July 11th, 2008 The stock market posted a negative second quarter and pushed its loss at the year's halfway mark to the double-digit level. Losses are hardly contained to the US; the pan-European Stoxx 600 index is off some 21% for the year, while in Asia, the Japanese Nikkei has dropped 12%, and emerging markets in India (-34%) and China (-46%) have suffered crash-level losses from their prior overheated condition. Although the long-term growth outlook remains attractive for these latter economies, their stock markets have reminded investors of the volatility common to developing markets.
A confluence of factors has contributed to the market weakness. The continuing housing downturn, and related problems in the mortgage and other consumer lending markets, are proving a slow-drip drag on consumer health, and US economic growth. The biggest driver of market weakness, however, and perhaps the most intractable at present, has been the sharp and prolonged rise in oil prices. Discussion: The Great Oil Shock of 2008 Considered in its historical context, the current energy situation constitutes the third oil "shock" experienced by the global economy in the last thirty-five years, and arguably the worst. In approximate terms, the price of crude oil has risen some 50% in six months, and has doubled in the last year. Crude oil ended the quarter at $140/barrel, helping in turn to drive average gasoline prices to over $4/gallon. These price levels represent all-time highs, even when historical prices are adjusted upward to current dollars, to account for inflation. The first oil crisis occurred in 1973-74, when OPEC oil nations curtailed shipments to the West, and in particular the United States, for their support of Israel in the Yom Kippur War. The average barrel price of oil almost doubled over the two-year period, from $23 to $41, as expressed in 2007 dollars. When the crisis hit, pump gasoline prices rose almost overnight by some 45%. Combined with loose central bank policies of the era, the Arab oil embargo was a key trigger for the slow growth, high inflation ("stagflation") conditions that defined the 1970s. A second oil shock occurred within the decade, in 1979-80, when the fall of Iran's Shah and the later onset of the Iran-Iraq war disrupted oil supplies to the world market. While crude prices did not spike as severely, they did rise from $74 to $98 (again, in 2007 dollars), and the economy suffered badly. The oil spike further fueled already-runaway inflation that was only ended with a bruising recession engineered by Paul Volcker's Fed that vanquished inflation, lowered interest rates, and restored investor confidence. Demand Growth is the Key Driver The high prices bedeviling the global economy today are not rooted so much in the geopolitical agendas of the past, but rather in a too-tight balance of supply with demand. Owning to years of economic growth and rising living standards, global oil demand has risen to some 86 million barrels/day, roughly in line with current supply capabilities. Moreover, demand growth is the greatest among regions and countries comprising the developing world Asia (especially China and India), Latin America, Africa and the Middle East, helped along in many cases by governmental subsidies intended to keep gasoline prices low. The developmental arc of these regions is secular, not cyclical, and we expect them to remain a persistent demand source for years to come. Apart from a tight market balance, there remain other contributors to the high price of crude. The much-maligned "speculators" who comprise energy and hedge fund trading desks have undoubtedly contributed some froth to the market. The Fed's current rate low-rate stance, and correspondingly weak dollar, have likely helped to boost the crude price, as has the continuing overhang of Mideast tension. Against this demand profile, global supply capabilities remain challenged. Gone (apparently; the Saudi oil industry is kept under a tight lid of secrecy by the kingdom) is the spare production capacity long possessed by Saudi Arabia, which represented "swing" production with which to influence prices. Most of the world's great oil fields (examples include Saudi's Gawhar, Alaska's North Slope, the North Sea, and Mexico's Cantarell) are in normal productive decline. What remains, at present, to replace that lost production are oil deposits in remote, dangerous parts of the world, often in highly technically challenging conditions such as in deep water, or in politically unstable areas such as Nigeria. There are encouraging new oil strikes, but their commercial production is several years away at the earliest. Best-known is the Tupi field in waters off Brazil. This play, in deep water, has offered tantalizing hints at Saudi-like production potential. Likewise, a consortium of companies last year announced encouraging drilling results in a block of the deep water Gulf of Mexico; as with Brazil's Tupi, commercialization is years off. Existing fields in Russia, other former Soviet republics, and Iraq all offer the high potential for greater production, although sometimes with political regimes not necessarily aligned with US interests. Where Do We Go from Here? Much like the consumer credit bubble discussed in our last quarterly note, our current energy dilemma was long in the making, variously due to laissez-faire governmental policy and largely indifferent consumer concerns, as long as cheap gasoline was to be had. At $4+ per gallon, with little hope in the short term for a significant price fall, consumers (and voters) are indifferent no longer, however, and indeed lie at the crossroads of solution. The closely linked phenomena of demand destruction and conservation will be instrumental in helping to bring prices down. High prices will ration (indeed, are rationing) demand by making petroleum products unaffordable, both to marginal business as well as strapped consumers. Consumers who might otherwise afford high prices will drive less, and use less energy at home it is entirely possible that a "Conservation Chic" movement might develop. Oil consumption may be displaced by other fossil-based (natural gas) or plant-based fuels, in industrial or home heating applications. Any conservation measures will, by necessity, involve changes to our automobile culture. At present, 45% of crude oil consumption in the US goes to produce gasoline for cars. In short order, we are already driving less. Consumer demand for smaller, more fuel-efficient cars employing hybrid technologies is fast emerging, while SUV sales and resale values are in freefall. It is true that we can't drill our way out of the problem, not nearly quickly enough anyhow, but the current oil crisis has unfrozen long-held partisan political postures in Washington on offshore drilling. It is probable that substantial oil reserves lie buried in the continental shelves off the nation's coasts, and we at last may have the impetus to approve drilling and fast-track the process. Likewise, high prices in general offer incentives to producers to explore for and produce new oil sources, or work over old ones. The Saudis may surprise us with extra production sooner than planned, also, as they have embarked on capacity expansion projects within their country. Last is the Holy Grail of alternate energy: wind, solar, fuel cells, or an as-yet unknown breakthrough technology that helps to wean us from oil and its refined products. It would seem that a solution remains long in the future. Thoughtful governmental policies may help to advance the science and economics of alternates, although that phrasing may be self-contradictory; witness the ongoing ethanol fiasco that is helping to drive food prices higher with limited benefits in the energy space. Rather than feel-good political talk of "Manhattan Projects" or "Marshall Plans," however, likely we advance on the fruits of small, incremental innovations from countless labs, businesses, garage tinkerers and entrepreneurs in driving down costs and improving efficiencies. Strategic's Investment Outlook At present, our outlook hinges on the unknown course of the price of oil. Without a break in the fever that is today's oil price, the global economy will struggle for traction, and entire industries such as autos, aerospace, and travel will be highly challenged. The economic outcomes from the modern era's two other energy shocks have not been benign, since high energy prices act as a large frictional cost on economic activity, akin to a tax increase. Slower economic growth, and incrementally higher inflation, are almost certain to remain with us for a time, as the shock's effects will impact the economy on a lagged basis. In lockstep with rising energy costs, the pressure on the domestic consumer continues to ratchet higher. By now, the recitation is a familiar one: falling housing, tight credit, sluggish wages, rising living costs. Notably, the principal credit lifelines of recent years to the consumer (home equity withdrawals, and credit cards) are less available. Banks, desperate to staunch additional losses, have tightened credit at precisely the time of need from their clients. Perhaps, we should complete the old saw that "bad loans are made in good times" with "and no loans are made in bad times." Equity Investment Strategy In our Quality Core strategy, we are holding above-average cash levels and continuing our underweight stance among financial and consumer-exposed companies. During the second quarter, we made minor capital adds to several stock positions that we believed to be attractively priced, and initiated small positions in industrial companies with energy efficiency and controls businesses, reflective of our thesis that energy prices will remain sticky-high. We are also mildly overweight the energy patch in this strategy. We were opportunistic with moves in our dividend-focused Equity Income strategy, adding to several positions while culling the portfolio of a distressed financial holding. We are taking steps to flavor Equity Income with a defensive, income-oriented tilt, which reflects our thinking of a slow-growth economy going forward. Here, also, we are mildly overweight our energy exposures. Fixed Income Strategy A seeming sense of rationality has returned to most credit markets in recent weeks. If credit markets are appearing to be once again wide, however, they are the proverbial inch deep fragile, and vulnerable to disruption. Treasury securities have remained a low-return safe haven for conservative investors, while the spreads in other taxable bonds have gradually widened on concerns over their credit quality in a weakening economy. We observe good relative value in high-grade Corporate bonds, and in Agency bonds, despite current concerns over the balance sheet health of Fannie Mae and Freddie Mac. We believe these entities will remain implicitly "backstopped" by the federal government, given their centrality to the functioning of the housing and mortgage markets. Municipal bonds have retained their relative appeal for us as well, for suitable accounts, based on their attractive pre-tax and tax-equivalent yield levels. Given the near-complete dissolution of the bond insurance market, however, we have sharpened our focus on the underlying creditworthiness of all municipals bought or held, preferring General Obligation bonds, and their broad taxing authority, to assure timely repayments to investors. As a continuing reminder, we limit our purchases of corporate bonds to those rated "A" or better, and we have avoided mortgage-related debt among individual bond holdings, with no plans to change this stance. Scott C. McCartney, CFA President and Chief Investment Officer Strategic Investment Advisors, Inc. Download This Market Report |
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