First Quarter Market Commentary
Let Them Eat Crude
By Robert Stimpson, CFA
Portfolio Manager
In the first quarter of 2011, the S&P 500 gained 5.9%. Late-stage cyclical sectors were strong performers, with Energy and Industrials leading the way. Not surprisingly, defensive sectors Staples and Utilities underperformed. Smaller stocks outperformed their larger peers, suggesting the appetite for risk remains strong. The market was able to overlook the turmoil in North Africa and disaster in Japan, demonstrating its resilience. It appears the market’s focus is squarely on the domestic economy and it expects further improvements in earnings and employment. As long as The Federal Reserve continues its loose monetary policy and company fundamentals remain strong, stocks seem eager to achieve higher prices.
World events over the past month have received a lot of media attention, but few accounts have emphasized the long-term effects on equity markets. The revolts in Tunisia, Egypt, Libya, unrest in Bahrain and Yemen, and the earthquake in Japan are significant for equity investors going forward. While most of the media have focused on the human aspect of the events, the influence of food inflation, rising oil prices, and the state of the US dollar have been overshadowed by the regime changes and nuclear disaster in Japan.
The concept of a revolution in itself is noteworthy and inspires strong historical associations. Indeed, the French, Russian, and American Revolutions receive their own college courses and high school text books. The Iranian Revolution is also well-defined in the American psyche following the embassy hostage crisis in 1979 and overthrow of the Shah. Despite the dramatic shift implied by a ‘revolution,’ in most instances, sustained change is not actually achieved to the degree desired. In states where populations have been oppressed for decades, education has been limited, and economies have been tightly controlled, democratic efforts often succumb to some form of new authoritative rule. The success of the recent political reforms in many of the countries undergoing revolt will take years, if not a decade to determine. Yet, the new regimes simply increase uncertainty in the region and portend further instability. Since one of the stock market’s core vulnerabilities is uncertainty, the political events in North Africa will someday rattle the market.
America’s prominent interest in the recent revolutions relates to oil and security of the Middle East. Libya is a small but important oil producer, accounting for 3% of global exports. In theory, Saudi Arabia can compensate for the lost capacity caused by the instability, but spare capacity itself has been estimated at less than 3%. Therefore, it may be more difficult for OPEC to fill the void, without even considering the actual spare capacity available or estimated reserves. For the most part, these figures are provided by the OPEC countries, are unaudited by a neutral party, and have a tendency to increase despite depletion, underinvestment, and even civil wars.
The wave of change sweeping across North Africa and the Middle East is more concerning for its potential destabilizing effect on leading oil producer Saudi Arabia. Despite stability within Saudi Arabia for decades, the underlying population looks very similar to that of Egypt and Libya: young, unemployed, tired of corruption, denied political freedoms and deprived of economic opportunities. There are, of course, sharp differences between the rule of Gadhafi and the House of Saud, but the winds of change are worrisome enough to threaten the Saudi ruling family. Since the uprisings began, Saudi Arabia’s King Abdullah has announced initiatives to promote education, social programs and housing worth over $10 billion, as well as a pay raise for government workers. When protests in neighbor Bahrain escalated, Saudi Arabia sent troops to suppress demonstrations. Like Saudi Arabia, Bahrain’s royal family is Sunni, ruling over a Shi’ite majority, a potentially fragile situation for both countries.
Strong political support from Washington is unlikely to aid the Saudi ruling family. The US had been a strong ally of Egypt’s Mubarak for decades for calculated reasons. However, its support for dictators like Mubarak in Egypt and Musharraf in Pakistan dilutes the US’s voice for democracy globally. As a result, the US may be disappointed with the relationship a new Egyptian government pursues, with not only it, but with China and Israel as a result.
Regardless of whether the Tunisian dominos will fall across the top of Africa and into the Arabian Peninsula, the instability and risks of an oil price shock remain. Iran will undoubtedly feel emboldened to instigate unrest outside it borders while suppressing any internal dissent. This too may add fuel to interest in gold, silver and other hard assets as investors seek so-called "safe havens" due to high volatility. Noticeably absent from this list of safer investments is the US Dollar and treasury securities, usual beneficiaries of the “flight-to-safety” trade.
The rebound in the US Dollar since the revolutions began has been short-lived. From its January high, the trade-weighted dollar has dropped 6%. The fact the Dollar has lost its reputation for safety could signal a bigger problem for the US government. Could it be the rest of the world is passively expressing their distain for quantitative easing, poor fiscal discipline, and support for a shift to world a where the Dollar is not the de facto reserve currency? I cannot answer this complicated question, but it is curious that the flight-to-safety crowd has favored the Swiss Franc, gold, and silver.
In the recent revolts and in other parts of the developing world, the role food inflation has played in recent geopolitical events has been often overlooked. Food inflation is a common destabilizing factor for revolutions and even inspired Marie Antoinette’s “let them eat cake” fallacy. Food prices are often the final straw and have been fueling global unrest for over a year. In 2010, food commodity prices soared; soy beans rose +34%, corn +56%, wheat +47%, cattle +25%, and sugar +25%.
In the developing world, food can claim anywhere from 30% to 50% of a household’s income. As food is not discretionary spending, the intolerance of food inflation is a larger cause of rioting than the philosophical ideals often purported by the Western media. Global markets determine prices for standard base sustenance and many countries must import grain or protein to feed their citizens. While some nations, such as Libya, Egypt, Iran, and Saudi Arabia are able to leverage their rich oil deposits to subsidize fuel prices, food must still be imported at global prices, making it hard for the governments to control food import prices.
Soaring food commodity prices have occurred for several factors, such as poor harvests in Russia, flooding in Australia, rising world demand due to growth in emerging markets, and quantitative easing in the US. With the rapid economic development in China, demand for grain has increased as citizens incorporate more protein into their diets. It takes 10 times more grain to feed a cow for beef production that it does to feed a human. As demand has risen, supply has also fallen following the 2008 recession and been exacerbated by regional harvest problems.
Loose US monetary policy has also exported inflation overseas. With US interest rates near zero, fiscal stimulus financially impossible and politically suicidal, the effects of the dollar and exchange rates are exacerbated. The Obama administration has stated its goal of doubling exports by 2015, a goal only achievable through a weak dollar policy. In turn, a falling dollar and quantitative easing have fueled commodity prices worldwide.
It is likely that the earthquake in Japan will add to global inflationary pressures, but also boost economic activity. Rebuilding efforts will compete for global supply of key commodities while also fueling regional economies, such as China and Korea. Japan’s trade balance will drop as the country replenishes its capital equipment and infrastructure. Since Japan generates 30% of its electricity from nuclear energy, alternative power sources, such as liquid natural gas (LNG), have already begun to anticipate tighter supply conditions. While the earthquake and tsunami were devastating, Japan has shown the ability to rebuild and will do so again. This might explain why the benchmark Japanese Nikkei Average has only lost 10% since the disaster.
Going forward, the events in North Africa alter the risk profile for equity investors, but for now, equities remain focused on the domestic economy and strong fundamental. A potential oil shock is now within the realm of possibilities - so too are flash points between Israel and its neighbors. Inflationary stresses are building and could pressure valuation multiples at some point. Fortunately, the near-term earnings outlook remains positive and when valuation multiples are pressured, growth stocks tend to outperform. The jobless rate continues to improve, though slowly. Manufacturing output, as measured by the ISM, has been surprisingly strong. So too have several economic data points in February. All of this suggests that the domestic economic recovery continues to progress. As an equity investor, this creates a good environment for stocks. But as always, we remain cognizant of cracks appearing in the market. Unfortunately, the revolts across North Africa have created a few more to watch.
Best regards,
Robert Stimpson, CFA
Portfolio Manager
Oak Associates Funds
This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.
The S&P 500 Index is an unmanaged index, and its performance does not reflect management fees, transaction costs or expenses. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighed index (stock prices times number of shares outstanding), with each stock's weight in the Index proportionate to its market value.
The Nikkei Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange.
One cannot invest directly in an index.
"Loose monetary policy" and "quantitative easing" are functions carried out by a central bank, through the use of open market operations (buying and selling government securities), which have the affect of increasing the supply of money in the financial system.