Pricey oil is deflationary, not inflationary threat
Reuters Business Channel Reuters.com
By Jeremy Gaunt, European Investment Correspondent
LONDON (Reuters) - Oil prices are rising again, but the threat to global investments is not what you might think -- deflation of the global economy rather than inflation of consumer prices.
Investors are generally calm about the prospect of spiking crude prices working their way into broad-based inflation and expect interest rates to stay low as a result.
They worry rather that higher prices will drag on economic growth and weaken company profits, in effect deflating relatively robust global economic performance.
"The action is on the economic side of the argument rather than the price side," said Philip Barleggs, head of allocation at Britain's Insight Investment.
One inference of this is that rising oil prices -- U.S. light sweet crude is trading around $67 a barrel -- could be more of a threat to equities, tied as they are to corporate profit growth, than to inflation-sensitive bonds.
Indeed, oil's price rise -- more than 10 percent so far this year -- has been a factor in recent global equity market weakness while helping demand for bonds whenever stocks decline.
"I wouldn't expect it to have a negative impact on bonds, rather the opposite if it were to increase further," said Christel Rendu de Lint, senior fixed income manager at Switzerland's Pictet Asset Management.
"The market is more looking at higher oil prices as a drag on growth rather than being inflationary," she said.
Slowing economic growth would tend to raise demand for safe-haven, fixed-income investments. By contrast, it risks dousing the fire of corporate activity and weigh on equities.
BREAK ON THROUGH
The main reason for the rather laid-back approach to the inflationary side of the ledger is that there has been little sign of it.
Although oil is up sharply over the past few years, inflation in leading countries remains benign and there has been scant carry over from oil to other prices.
At the same time, oil's lack of impact on inflation can be seen in the relative performance of its price and that of the yield on long-term government bonds.
Since the beginning of 2004, the cost of a barrel of light sweet crude has risen around 110 percent. Yields on euro zone debt, by contrast, have fallen and those on U.S. bonds stayed relatively level given the U.S. Federal Reserve's tightening.
Inflation, in other words, is not being priced by investors into long-term interest rates despite the rising oil price.
Like many things, the explanation is globalization. Although higher oil prices act like a tax on both workers and employers, neither is in a position to do much about it.
Industrialized country workers, who in the past would have demanded higher wages as costs rose, find themselves competing with far cheaper labor in China, India and eastern Europe.
Indeed, some of the stellar performance of equities over the past few years has been as a result of wage restraints and labor force reductions prompted by this competition.
But enhanced global competition has also stopped companies from passing on costs to consumers.
"When oil prices rise it adds to the cost of companies while at the same time they cannot increase their selling prices. This hurts profit margins," said Klaus Wiener, head of asset management research for Italy's Generali Group.
"That's why the oil price today works (at) deflation not inflation."
STRANGE DAYS
Another factor keeping investors relatively calm about inflation is the rather contradictory belief that monetary authorities will act to snuff out price rises if they do start breaking through from energy into second-round costs.
"We are pretty sure that inflation is not going to rise because the credibility of central banks is so strong," said Benjamin Melman, head of strategy at Credit Agricole Asset Management.
In this vein, some analysts detect a recent change among European Central Bank officials about oil.
"(ECB policymakers) have put their emphasis on the linkage between inflation or price stability risks and oil prices rather than the growth side," said Alessandro Tentori, bond strategist at BNP Paribas.
That could mean higher rates -- not good news for bonds or equities.
And just because all these factors have combined to keep the inflationary impact of higher oil prices in check so far does the mean that will always be the case.
"The lack of pass through has been amazing, but we have to remain careful," Melman said.
The rub is that higher oil prices, by threatening the very global growth that has kept them going strong, could be sowing their own deflationary demise.
"If prices are sustained around $100, oil demand would probably go negative," said Leo Drollas of the Center for Global Energy Studies.
Not much comfort to investors for now.
By Jeremy Gaunt, European Investment Correspondent
LONDON (Reuters) - Oil prices are rising again, but the threat to global investments is not what you might think -- deflation of the global economy rather than inflation of consumer prices.
Investors are generally calm about the prospect of spiking crude prices working their way into broad-based inflation and expect interest rates to stay low as a result.
They worry rather that higher prices will drag on economic growth and weaken company profits, in effect deflating relatively robust global economic performance.
"The action is on the economic side of the argument rather than the price side," said Philip Barleggs, head of allocation at Britain's Insight Investment.
One inference of this is that rising oil prices -- U.S. light sweet crude
Indeed, oil's price rise -- more than 10 percent so far this year -- has been a factor in recent global equity market weakness while helping demand for bonds whenever stocks decline.
"I wouldn't expect it to have a negative impact on bonds, rather the opposite if it were to increase further," said Christel Rendu de Lint, senior fixed income manager at Switzerland's Pictet Asset Management.
"The market is more looking at higher oil prices as a drag on growth rather than being inflationary," she said.
Slowing economic growth would tend to raise demand for safe-haven, fixed-income investments. By contrast, it risks dousing the fire of corporate activity and weigh on equities.
BREAK ON THROUGH
The main reason for the rather laid-back approach to the inflationary side of the ledger is that there has been little sign of it.
Although oil is up sharply over the past few years, inflation in leading countries remains benign and there has been scant carry over from oil to other prices.
At the same time, oil's lack of impact on inflation can be seen in the relative performance of its price and that of the yield on long-term government bonds.
Since the beginning of 2004, the cost of a barrel of light sweet crude has risen around 110 percent. Yields on euro zone debt, by contrast, have fallen and those on U.S. bonds stayed relatively level given the U.S. Federal Reserve's tightening.
Inflation, in other words, is not being priced by investors into long-term interest rates despite the rising oil price.
Like many things, the explanation is globalization. Although higher oil prices act like a tax on both workers and employers, neither is in a position to do much about it.
Industrialized country workers, who in the past would have demanded higher wages as costs rose, find themselves competing with far cheaper labor in China, India and eastern Europe.
Indeed, some of the stellar performance of equities over the past few years has been as a result of wage restraints and labor force reductions prompted by this competition.
But enhanced global competition has also stopped companies from passing on costs to consumers.
"When oil prices rise it adds to the cost of companies while at the same time they cannot increase their selling prices. This hurts profit margins," said Klaus Wiener, head of asset management research for Italy's Generali Group.
"That's why the oil price today works (at) deflation not inflation."
STRANGE DAYS
Another factor keeping investors relatively calm about inflation is the rather contradictory belief that monetary authorities will act to snuff out price rises if they do start breaking through from energy into second-round costs.
"We are pretty sure that inflation is not going to rise because the credibility of central banks is so strong," said Benjamin Melman, head of strategy at Credit Agricole Asset Management.
In this vein, some analysts detect a recent change among European Central Bank officials about oil.
"(ECB policymakers) have put their emphasis on the linkage between inflation or price stability risks and oil prices rather than the growth side," said Alessandro Tentori, bond strategist at BNP Paribas.
That could mean higher rates -- not good news for bonds or equities.
And just because all these factors have combined to keep the inflationary impact of higher oil prices in check so far does the mean that will always be the case.
"The lack of pass through has been amazing, but we have to remain careful," Melman said.
The rub is that higher oil prices, by threatening the very global growth that has kept them going strong, could be sowing their own deflationary demise.
"If prices are sustained around $100, oil demand would probably go negative," said Leo Drollas of the Center for Global Energy Studies.
Not much comfort to investors for now.
posted by Marcel at 10:52 AM
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