Market View - April 2012

As the first quarter of 2012 came to a close, the current cyclical bull market that commenced in global equities last autumn remained intact albeit the momentum had slowed somewhat during the second half of March.

The star of the global equity indices during the first three months of this year was undoubtedly the Nikkei 225 in Japan which was up 19.26%, although the NASDAQ Composite in the US ran it close with a rise of 18.67%. Rather disappointing by comparison were the relatively lacklustre returns from large caps in both the UK and mainland China (FTSE 100 up 3.52% and the Shanghai Composite plus 2.88%), while bonds as measured by the JP Morgan Global Bond index fell almost 1%.

Much more encouragingly, the S&P 500 in the US grew 12% over the first three months of 2012, representing its best quarterly return since 1998, while in the broader context (post the Lehman Brothers collapse), the S&P 500 closed the first quarter 108.2% above its March 2009 closing low and just 10% below the nominal all time high reached in October 2007. Elsewhere during the first quarter, the German Dax index rose 17.30%, the Hang Seng in Hong Kong climbed 11.51%, and the BSE Sensex in India was up 12.61%.

As ever however, there are always dark clouds on the horizon and currently the most menacing ones take the shape of rising energy prices, a potentially worse than expected slowdown in China’s economy and a stubbornly slow recovery in Europe. The two latter factors appeared to be adversely impacting US corporate profit growth during the last quarter which is not surprising as large US international companies quoted on the S&P 500 derive 40% of their profits from abroad.

Potentially most worrying of all as the global economy seeks to get traction under its slowly developing recovery is the future price of energy, and a recent article in The Economist newspaper (Oil prices – Keeping it to themselves) highlights the likely relentless upward pressure on the price action when it says “Everyone knows why the oil price, around $125 a barrel of Brent crude is so high. The long term trends are meagre supply growth and soaring demand from China and other emerging economies, and in the short term, the market is tight, supplies have been disrupted and Iran is making everyone nervous”.

The article goes on to quote how for example China increased its consumption 90% or by 4.3 million barrels per day (mbpd) between 2000 and 2010, and now consumes over 10% of global oil, while the country that increased its consumption by the second highest amount during the noughties was Saudi Arabia, from 1.6 mbpd, to 2.8 mbpd, making it now the sixth largest consumer of oil in the world! Just as importantly The Economist continues, “The Middle East, home to six OPEC members, saw consumption grow by 56% in the first decade of the century, four times the global growth rate and nearly double the rate in Asia.”

This problem is prevalent throughout the Middle East as populations have expanded, while heavy subsidies of fuel and electricity have continued resulting in oil remaining the primary energy source despite the abundance of comparatively cheap gas. The Economist article concludes “The longer term picture is equally worrying as global demand for oil is projected to rise to over 100 mbpd by 2030, but meanwhile Iranian oil production will decline as sanctions bite and the country loses access to equipment and expertise.

“Iraq currently producing 3 mbpd has the reserves to increase production significantly but fragile politics, dodgy security and battered oil infrastructure are deterring the investment required to boost supplies, while Saudi Arabia’s thirst for its own oil shows little sign of abating. The Gulf is usually seen as the answer to the world’s oil problems, but it looks ever more like a question mark instead.”

Conceivably the global market (especially if the recovery in Western developed economies can gather momentum) can cope with an increase in oil prices provided it is orderly and gradual, but a short term shock could be much more damaging. Provocative military action from the US and / or Israel towards Iran is an obvious risk that could at least temporarily result in oil topping $200 were the Straits of Hormuz to be closed, while overreaction from the inflation obsessed ECB resulting in higher rates (instead of ideally cutting rates further) is also a worry.

The Economist believes most emerging economies are less vulnerable to costlier oil this time around, as food inflation has been broadly flat, although the Indian economy may be a concern because it is running large current account and budget deficits while subsidising the prices of Kerosene and diesel. Another concern is the risk of US petrol taxes being cut in an election year if crude continues rising (i.e. politicians +pump prices + poll = panic), or even worse (as Obama did last summer) we get the premature release of the country’s strategic oil reserves in order to try and dampen prices, and The Economist concludes that in a nutshell “The odds of averting a 2012 oil shock depend disproportionately on America keeping its cool both at home and abroad”.

Looking forward it may be worth quoting the man widely acknowledged as the most successful bond investor of all time, namely Bill Gross the joint CEO of PIMCO who said in his recent newsletter to clients “In a mildly reflating world, unless you want to earn an inflation adjusted return of minus 2% - 3% as offered by Treasury bills, then you must take risk in some form. We favour high quality, shorter duration and inflation protected bonds, dividend paying stocks with a preference for developing over developed markets and inflation sensitive supply constrained commodity products”.

Gross is of course addressing US based investors, and the Ash-Ridge Asset Management strategy will accordingly differ in that our higher yielding stocks and non government bond allocations will have a UK centric bias. For now the cyclical bull market remains intact, but arguably within a longer term secular bear market that began in July 2000. Accordingly we must keep in mind Warren Buffett’s two golden rules for investing: Rule No 1 – Never lose money. Rule No. 2 – Never forget Rule No.1!