July 2008: Whither the Price of Oil?
Worldwide equity markets today are locked into a nasty, negative correlation with the price of oil. With nearly 93% of the world’s petroleum reserves owned and controlled by unstable, autocratic governments, the U.S., and most free-market economies, is confronted with an extraordinary dilemma. On the one hand, globalization has redistributed manufacturing and production capacity throughout the planet, balancing and diluting any product pricing power that might have once existed; on the other, oligopolistic energy production and pricing control is concentrated in the hands of a few whose priorities are very different from ours. The resulting geopolitical disconnects dominate the diplomatic agenda, whether it be the West’s relations with Iran or the G-8 Summit in Japan.
Psychologically, of course, $140/barrel oil translates into at-the-pump gasoline prices which affect our frame of reference daily for just about every consumer energy-based expense. However, as Ben Stein recently pointed out, even factoring in the latest increases, the purchase of gasoline and oil in the U.S. amounts to a relatively small 3.0% of total personal consumption expenditures. He estimates that the average annual gasoline bill for the typical U.S. driver (who travels 12,000 miles per year and gets 15 mpg) may have risen from $3,200 to $3,600. The issue for many is that real wage growth since the 1970’s has been stagnant and against this background the constant reminder of rising costs at the pump, as well as with each heating oil bill, disproportionately impacts our perception of reality. The media, needless to say, distorts and exhorts; our politicians spew rhetoric and hold hearings. Add to all this the resulting re-emergence, after some 15 years of quiescence, of rising inflationary expectations, a deteriorating dollar, continued problems in our housing and credit markets, and predictably the financial markets react and have begun to discount worst-case scenarios. Each feeds upon the other; the cycle seems locked into unbreakable concentric circles. For longer term investors, the challenge becomes how to remain rational in an apparently increasingly unstable world.
Inflation: The Financial Markets' Current Obsession
The root driver ultimately underlying the direction of stock prices will be how inflation, and just as important, inflationary expectations, plays out over the coming months. Against a global backdrop of what one economist terms “languid” growth, our central bank, the Federal Reserve Board (Fed), has signaled an end to its easy money policy of the past 10 months. Domestically, because the Fed has had to intervene so aggressively to contain the effects of first, the tech stock blow-up in 2000-2002, and more recently, the housing collapse still underway, any turnaround in our credit and equity markets could take longer than many anticipate. The massive amounts of liquidity injected into our banking system over the past 7-8 years have begun to emerge in the form of increasing inflationary pressures (today’s Consumer Price Index or CPI, realistically adjusted, is probably rising at a 4.5% rate year-over-year), however, core inflation rates excluding energy and food are up more modestly. Even if the Fed can muster the political resolve, it will take possibly a few years to redress the money supply imbalances embedded in our banking system currently.
Most other free-market countries also face similar adjustments, but many do so against a backdrop of stronger economic growth prospects. Consensus GDP growth forecasts for the U.S. this year, and for 2009, averages out to around 1%; for most other free-market economies it is closer to 3.5%. If these predictions prove accurate, the much anticipated recession for the U.S. may turn out to be only a mild slowdown, but because of the backlog of liquidity which must be worked out of our financial system, the equity and credit market retrenchment may continue for an extended period.
In the final analysis, inflationary expectations set the range, structure and level of interest rates. And the resulting conditions in our credit and bond markets influence the price-to-earnings valuations driving stock market appraisals. All of this affects the cost of doing business, employment growth, and consumer spending priorities. Economists like to think of these relationships as a tightly-linked causal chain, and to some extent, it follows this theoretical path. However, neat economic models such as these often run aground because of local and national political detours. For example, today’s price of corn, which affects many other basic food costs throughout the world, is artificially driven by misguided congressional biofuel subsidy programs. The politics behind this are transparent enough, as are those underlying the recently passed bloated farm subsidy legislation, but the pernicious, inflationary effect on global food costs plays out as yet another example of the law of unintended consequences.
Although near-term inflationary expectations seem to be heating up, a return to a 1970’s era spiraling CPI pattern coupled with stagnant growth seems unlikely. Since the early 1980’s, due in part to our country’s yearly current account deficits and the more balanced nature of the increasingly globalized developing country economies, most developing country government and corporate balance sheets, and currency reserves, have strengthened measurably. Linked to our economy, but no longer so dependent upon it as in the past, many of these countries are managing their national finances more effectively. The majority of these countries have also adopted the U.S. independent central bank model (Federal Reserve System) which in turn has the primary goal of controlling inflation. The European Central Bank, generally very sensitive to leading inflationary indicators, has just edged up its short-term borrowing rate, signaling concern with the impact of rising oil prices. Our Fed may find that by the end of this year, it will have no option but to do the same. The point to be made is that counter-inflation policies are already being instituted.
Portfolio Concerns and Opportunities
Investors and investment markets abhor uncertainty. Although ambiguity dominates presently, for patient investors with the longer view, it might pay off later to look for opportunities amongst today’s equity markets debris. Of course, the first order of battle is to protect one’s flanks; preserve what you have. What one avoids or doesn’t own is often as important as the positions held. For the most part, during the quarter ended June 30th, our portfolio equity mix, although down in value, performed better than the widely followed market indices. Throughout the quarter, the main source of strength came from the natural resource sector. Most other equity asset class segments performed in line with or slightly better than their benchmarks; however, if the markets weaken further and if energy or commodities prices decline, it would not be surprising to see even the natural resource segment come under pressure.
Where do we see opportunity today? In the last few trading weeks, the Japanese stock market has weakened noticeably which may offer a chance to increase that position beyond our original market-neutral goal. The attraction here is purely price; Tokyo stock market valuations are near 20-year lows. As real estate markets around the world continue to reflect increasing pessimism, Real Estate Investment Trusts (REITs), an asset class some clients will remember we avoided in the past, begin to suggest interesting potential from a yield, diversification and long-term appreciation standpoint. Although more turmoil in the commercial real estate and housing markets is still likely, many global REITs today sell below their per share net asset value. Well-capitalized REITs in the months ahead will have an opportunity to purchase distressed real estate at discounted prices.
More broadly considered, equity markets globally appear reasonably priced relative to projected earnings (i.e., in the range of 13-15x estimated 2009 earnings per share), a level not experienced since the mid-1980’s. However, for the moment, emotions hold sway in the market, masking what would seem to be some interesting opportunities for long-term investors. We will be attempting to identify and take advantage of some of these realignment possibilities in the weeks and months ahead.
Planning Alerts
In the fall and immediately following the November general elections, wealth managers, CPAs and lawyers will be thinking through the income, capital gains, and estate tax implications of the election’s aftermath. All scenarios point toward rising ordinary income and capital gains tax rates. Prospects are that a compromise Federal estate tax lifetime exemption of $3.5 million for each individual will emerge. The latter means that for carefully planned estates, with all property correctly titled, a married couple can pass $7.0 million in assets without Federal estate tax onto the next generation by the time of the death of the last to survive. As always, care must be taken to deftly word and coordinate all the estate planning documents to assure language crafted in outdated plans under previous state and Federal laws does not conflict with the new expanded exemption limitations. In collaboration with your estate planning attorney, we will be covering this as part of our routine check list at future review sessions, but if in the interim you have questions about how this might play out, please do not hesitate to check with us.
The other planning opportunity which will begin to gain the attention of financial services professionals is the conversion of present conventional IRAs to a Roth IRA. We will be sending out shortly, as well as posting to our website, a piece prepared for clients discussing the Roth IRA options; but suffice it to say, if ordinary income tax rates are going up, for individuals with substantial present retirement plan assets, a Roth conversion should be carefully considered. Such a conversion could save you and your heirs a substantial amount of future income taxes, but the timing and steps followed to achieve this goal must be carefully managed to gain the desired tax savings.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO