Mid-year, equity markets are close to local cyclical highs and risk aversion remains very low according to the VIX. While most remain constructive on equities this year, two major risk factors could disrupt this happy state of affairs.
First, the end of the “Goldilocks” period that began in mid-2012 meaning that at least some major Central Banks are forced to think about scaling back monetary accommodation in the face of medium term inflation pressures. The “Goldilocks” period can be described as an era of accelerating AE growth combined with flat to lower inflation. Banks most likely to scale back are the BoE and the Fed. However, the recent FOMC suggests that at least the Fed is not there yet.
Second, supply shocks could generate higher oil prices which would be a significant threat to the economic recovery both in advanced and emerging economies. In some cases, higher oil prices are not always bad for economies and markets. If real GDP growth is on a strong trend already, higher oil prices, better economic and earnings data, stronger demand for energy and higher equity markets can all co-exist nicely. For historic examples, look at the period from 1999 – 2000 or 2005 – 2006. Contrary to those periods, when oil inflated oil prices result from supply shortages, both the reduction in quantity and the higher prices will tend to hit economic activity. According to the chart below, every US recession bar with the exception of one since the mid-1970’s has been associated with a spike in oil prices…
Since the end of 2011, the correlation between equities and oil has been near zero. This was not the case over 2010 – 2011 as quantitative easing and liquidity drove returns in all asset markets concurrently. While the correlation remains at these levels, oil futures or even commodities are a solid way to diversify a portfolio and hedge equity positions.
There is still a real risk of serious disruptions to oil supplies in Iraq. The ISIS/ISIL forces have experienced limited success in the oil fields to the North, while fields to the south are under threat. The international community, including the US, has no appetite for direct military intervention at this time.
In general, it feels like oil markets are already tighter than many forecasters thought about 6 – 12 months ago. The prevailing softness coupled with supply shock in Iraq would raise the risks considerably as Iraq current outputs about 3.2 million barrels per day or roughly 9% of the OPEC total. There is more spare capacity available elsewhere but it is concentrated in countries like Libya and Nigeria where geopolitics are also playing a role in constraining supplies.