A year ago, the US economy appeared to be on the mend, jobs creation was picking up and the European debt crisis was off the front pages. Not surprisingly, the stock market and other economy-sensitive assets like metals and high-yield bonds rallied.
Three major shocks brought the economy and financial markets to their knees by mid-2011: a spike in oil prices due to civil war in Libya, manufacturing supply chain disruptions resulting from a devastating earthquake in Japan and a re-intensification of the European sovereign credit crisis. Exacerbating the malaise, of course, was the high-profile debt ceiling debate in Congress over the summer, a debacle that ultimately cost the United States its coveted triple-A bond rating.
As predicted in PF Weekly, fears about a double-dip recession in the US were way overblown last summer. As the temporary shocks of spiking energy costs and manufacturing supply chain disruptions faded, the US economy re-accelerated and began to surprise on the upside.
And while the EU sovereign credit crisis is serious, we were also broadly correct to suggest that EU leaders would ultimately take any steps necessary to prevent Europe’s credit problems from devolving into a 2008-style global credit crunch. After plenty of experimenting, frustrating indecision and infighting in Europe, the European Central Bank (ECB) delivered the magic medicine: a three-year Long-Term Refinancing Operation (LTRO) at a 1 percent interest rate.
The LTRO essentially allowed banks to post a wide variety of collateral to obtain loans at ultra-low interest rates for a period of 36 months. This alleviated concerns that a major European financial institution could go bust. It also reduced all-important Italian and Spanish government borrowing costs via a carry trade – the LTRO allows banks to borrow money cheaply from the ECB and purchase Italian and Spanish bonds yielding far more than their cost of capital to earn a profitable spread.
The ECB plans its second LTRO at the end of February and European banks are expected to soak up as much as an additional 450 billion euros ($600 billion). Clearly, the LTRO doesn’t solve the long-term problem, because many European governments have spent way too much money and have taken on too much debt. However, it did resolve immediate liquidity and funding concerns.
As these fears subsided, market participants found themselves considerably underinvested — the rush to buy into risky assets is behind the breathtaking market rally off last October’s lows. All major US indexes are either testing or have already exceeded 2011 highs.
Looking ahead, the big concern for the global economy and market is the potential for a fresh slate of economic shocks to prompt a repeat of last year’s mid-year slump. When the economy exhibits strong momentum, it can sustain the occasional economic shock and keep growing. To be sure, the US economy is firming up, but the recovery is fragile and more vulnerable to shocks than would normally be the case. Growth is hardly robust by any historic standard and unemployment remains above 8 percent.
As I’ve written on several occasions, the biggest threat facing the US economy over the next year is uncertainty surrounding the US presidential election and, in particular, tax/fiscal policy heading into 2013. As I explained in an article for SeekingAlpha, “My 2012 Investing Cheat Sheet,” several significant tax increases are poised to hit the US economy starting in 2013. As a percentage of Gross Domestic Product (GDP), the concomitant fiscal contraction would be the largest in post-war economic history.
It’s important to understand that these tax increases represent the status quo – they will go into effect if Congress and the president do nothing to repeal them. Considering the partisan rancor on Capitol Hill and the fact that this is a presidential election year, it’s extremely improbable that the two parties will come together on any sort of grand compromise on tax and spending policy ahead of November. A more likely scenario is that both parties continue to propose policies that appeal to their core base of supporters. I see this uncertainty as a huge headwind for the market in the second half of 2012.
Moreover, a spike in crude oil prices eerily reminiscent of early 2011 is another near-term shock to the global economy. One measure of stress on the consumer I watch is US headline inflation minus core inflation; check out my chart below for a closer look.
Headline CPI measures total price increases for US consumers across the entire economy while the “core” version of CPI excludes volatile food and energy prices. When the headline inflation is well above core inflation that suggests that the main driver of price increases on the consumer is higher food and energy prices – negative energy price shocks will show up on this measure in the form of a big spike to the upside from headline minus core.
My chart illustrates this measure going back to early 2005. As you can readily see, the US economy experienced a big energy and food price shock in the first half of 2008, ultimately one of several factors that hit the economy hard into year end. More recently, you can see that the US economy experienced another big shock starting in late 2010 and persisting until June of 2011. This negative shock was due primarily to spiking oil prices during 2011’s Arab Spring uprisings.
Over the past four months, this measure has been benign, as energy costs came down sharply from their early 2011 highs and food costs also moderated a bit towards the end of last year. This represented a significant tailwind for investors, because falling food and energy prices freed up more disposable income to spend on other things.
This measure was fairly tame to the end of January but that’s about to change. US benchmark West Texas Intermediate crude oil prices have spiked from around $98 per barrel as of the end of January to nearly $109/bbl as of late February. The situation looks even worse when you consider Brent crude oil, a more important benchmark for the world a s a whole; those prices have rocketed from an already-elevated $110/bbl as of the end of January to $127/bbl more recently, right back at their 2011 highs. US retail gasoline prices stood at $3.20 per gallon in mid-December but have since spiked to $3.65 per gallon, a level that’s considerably higher than the $3.24/gallon they traded at one year ago.
The US consumer and the stock market tend to respond negatively to higher energy prices, although the response usually comes with a significant lag. In other words, it takes a few months for higher energy prices to really begin to bite the economy. In 2011, for example, gasoline and crude oil prices began to spike early in the year but US economic data didn’t really start to disappoint expectations until April/May.
So far, we haven’t seen much of an impact on the consumer from higher energy prices. Jobless claims continue to fall with the four-week moving average of claims recently tumbling to their lowest levels since early 2008. And US home sales data continues to come in better than forecast. But over time, if the spike in oil and gasoline prices continues, it would begin to take its toll on the economy
That said, the US is extraordinarily lucky in this regard relative to the rest of the world, as I explained in the December 15, 2011 issue of Personal Finance Weekly, “America’s Overlooked Energy Advantages.” US crude oil markets are better supplied than any other major market in the world, thanks to continued growth in US production from unconventional plays like the Bakken Shale of North Dakota. A surfeit of crude at the Cushing, Oklahoma terminal is the main reason that West Texas Intermediate oil is trading at a near-record discount to Brent crude oil.
Of course, Americans are too quick to forget the huge advantages afforded the nation by its natural gas resource wealth. While US gas prices hover near decade lows, gas costs in Europe and Asia are 4 or 5 times higher. US electricity costs are actually falling, even as many European consumers contend with 30 to 60 percent year-over-year increases in some cases. And, unseasonably warm winter temperatures across broad swathes of the US, coupled with cheap gas costs, have pushed down home heating costs significantly, cushioning the blow of higher gasoline prices.
I’m more worried about the potential impact of higher energy prices on already hard-hit European economies. Check out my chart below.
Source: Bloomberg, BP Statistical Review of World Energy, World Bank, IEA
To construct this chart I simply looked at historic global crude oil consumption and forecasts for global consumption in 2012. I then multiplied these consumption numbers by averaged Brent crude oil prices for each calendar year. As you can see, even though oil prices were a bit higher in the summer of 2008 than they were in 2011, higher global oil consumption meant that consumers worldwide actually spent more than 5 percent of global GDP on oil alone in 2011. If IEA projections or 2012 oil demand are even close to correct, we’ll see oil costs approach 6 percent of global GDP in 2012, the highest levels since the oil shocks of the 1970s.
I don’t yet see evidence that rising energy prices are derailing the global economic recovery; they’re NOT a reason to panic and sell all your positions. But energy prices will be one of the most important risks to watch in the first half of the year. These trends suggest it’s prudent for investors to take some profits off the table in stocks that have rallied sharply over the past few months.