Hamish McRae: Rising oil price usually means recession. So why are share markets up?

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The Independent Online

It is a huge conundrum, isn't it? The oil price creeps ever higher, hitting fresh highs again yesterday, yet shares here in the UK and in most other major markets are close to their highest levels since the bottom of two years ago (in the case of the US) and of spring 2003 (in the case of the UK).

It is a huge conundrum, isn't it? The oil price creeps ever higher, hitting fresh highs again yesterday, yet shares here in the UK and in most other major markets are close to their highest levels since the bottom of two years ago (in the case of the US) and of spring 2003 (in the case of the UK).

This ought not to happen. Oil reaches into every part of the world economy, for all energy prices are affected by it. You may not accept the mechanistic relationships that are sometimes advanced, such as that $10 on the oil price knocks a bit less than 0.5 per cent off global growth. But it must be bad news for a world economy that is already facing a slowdown and higher interest rates, and that has huge unresolved problems such as the size of the US current account deficit and weak consumer demand from the eurozone.

If you look further at both the oil market and equities, it is easy to make a case for more gloom. In the oil market, the problem is mainly one of strong, sustained demand not, as in previous oil squeezes, artificial restrictions to supply. China, already the second largest oil importer after the US, is not going to cut back its purchases in the foreseeable future. While there have been some disruptions to supply, the oil producing world in general, and Saudi Arabia in particular, are trying to increase production, not cut it back. The problem is that there is hardly any spare productive capacity in the world.

As for equities, there seems to be a fundamental psychological shift away from the cult of the equity. That is not just the result of the worst bear market for a generation, devastating though that has been. It is also a function of regulation. Pension funds across the world are being forced to switch to securities that will give some form of guarantee of solvency, which means the proportion of equities has to be reduced. They have to try to match liabilities and assets, something that is extremely difficult to do with a large weighting in shares. Further, investors have other options in property and private equity that appear to offer better prospects for those investors that can still take on an element of risk.

So what is happening? Here is a possible line of explanation and a thought for the future.

The explanation has several elements to it. Starting with the oil market, it is important to recognise that in real terms oil, while expensive, is not ridiculously so. The real oil price peaked at more than $80 a barrel in today's money during the 1979/80 crisis. Given the present weakness of the dollar, the price in euros or sterling is lower still. There could, of course, be a panic in the markets in the next few months, with prices rising still further. But the general perception is that while this may not be the top of the market cycle, the price is already above its long-term equilibrium level.

There is a further twist here. We are coping. Companies are coping with higher energy costs; people are coping without severe changes in their lifestyles. Growth had to slow anyway - that was one of the reasons why interest rates had to go up. So in a way rising oil prices are doing the job that rising interest rates would have had to have done: to take demand out of the world economy. If that is right, then interest rates will not have to rise by as much as they would have had to have done. This is very good news for highly geared economies, such as the US and UK, and of course for equities.

That leads to the equity side of the equation: why are they doing so well?

Well, the first thing to say there is that they are not. It is a sort of bull market but it started from a very low base, particularly in the UK, and it is still very immature. It certainly has not been associated with the solid support you would normally expect in what ought to be still the early stages of a bull market. The value available in UK shares ought to be sucking in more money than it has been doing. I am sure were it not for the confusion over pension fund regulation and the lagged impact of the Chancellor's tax raid on the funds, shares would be higher and actually less good value.

It would follow that in so far as shares are doing all right, it is because there are a lot of companies out there doing all right: profits have in general been good. Besides, where is the value elsewhere?

There is not much evident value in the bond markets. It varies a bit from country to country and currency to currency but in general long-dated government securities are yielding less than 5 per cent, in some cases quite a bit less. That does not give much protection against inflation, given that governments will have a huge incentive to generate a bit of that to reduce the real burden of the debts they are building up. Nor is there much obvious value in most forms of property, commercial as well as residential, in the US, UK and other major markets. Set against these, shares do not look too bad an idea.

If there is not much value in non-equity investments, there is a lot of money trying to find a home. One of the effects of a long-ish period of very low interest rates in the US and the eurozone, and an even longer one in Japan, is that a lot of money has been created by the central banks. The world is awash with liquidity. With still negative real short-term interest rates in the US and parts of the eurozone, there will be a lot of money around for a while yet. One should not quite say that it has to go somewhere - that is a dangerous basis on which to operate because money can be destroyed, as it was by the bursting of the hi-tech bubble. What one can say is that a growing world economy does generate growing savings somewhere and it would be odd if some of those savings did not find their way into the world's major equity markets, including London.

That might seem a rather grudging endorsement of the case for equity investment and I suppose it is. But that is what the investment world will be like for the next few years. The psychological and financial damage of three consecutive years of falling share prices will be with us for a decade. The blithe certainty that professional investors could rely upon that shares would deliver double-digit returns pretty reliably year-in, year-out is shattered. What is happening on the equity markets is a sensible, practical recovery against a still-strong psychological and technical headwind. Were the oil markets less edgy, shares would be doing better still.

To explain is not to predict. But if the argument sketched above is more or less right, then any significant easing of the oil price would be helpful to share prices as well as to the world economy in general.

That would be one of a series of comfort signals that investors are seeking. Others include the US doing something about its twin deficits, evidence of a "soft landing" in Chinese growth, and a European consumer recovery. So it is only one of several. But given the stark fact that three of the past four world recessions have been triggered by a rise in the oil price, it would be a nice signal to have in the bag.

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