Oil Becomes The New Defensive

Rudi Filapek-Vandyck

"We no longer doubt that the US administration’s proposals signal the direction of trade policy. An escalatory cycle of protectionist actions, not just rhetoric, has begun and will continue. It’s another reason why pressure should continue in risk markets, which now must eat their US policy vegetables after feasting on dessert in 2017." [Michael D Zezas, Strategist & Chief US Public Policy & Municipal Strategist at Morgan Stanley, US]

If you want to look for a reason behind the Australian share market's surprising outperformance in the June quarter, look no further than the fact Australia is one of the world's primary producers of fossil fuels.

This might seem like a rather awkward explanation, but in the face of an increasingly uncertain outlook for global trade, and for risk assets, and with US government bonds not playing to script and the stronger US dollar playing havoc, the global investment community seems to have decided that when it comes to finding a solid safe haven, under-supplied and well-supported crude oil and related markets will do.

Observe the steep price trajectory in crude oil futures over the past two-three weeks. Share prices for oil producers across the globe have rallied almost one-on-one with the price of crude. But this equally applies to discretionary retailers, financials and shares in general for markets in Oslo, Toronto, and here in Sydney.

All three equity markets are among the best performing year-to-date. All have one thing in common: respective countries are major producers of energy.

It appears the world has decided nobody's going to spoil this party anytime soon. Outside of Russia and Saudi Arabia, most producers, including number three the USA, are hampered and unable to significantly lift output volumes in the near term. Meanwhile, risks are plenty and there for all to see: from Venezuela, to Iran, and elsewhere.

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At face value, shifting funds into oil producing nations makes sense. More revenues means higher tax incomes, means more investment and higher wages; it should all translate into stronger economic growth domestically, especially when a stronger US dollar adds to the risks that are descending upon emerging markets.

Many of the emerging markets are net consumers of fossil fuels. And heavily indebted in USD. Industry data are indicating investors continue shifting funds away from emerging markets, both equities and bonds. Last week I suggested Australian equities had likely become one of the accidental beneficiaries.

This has become even more likely now, despite the Australian dollar weakening, with analysts overseeing emerging markets concerned a bear market might have started. Chinese equities (Shanghai Composite index) already have fallen more than -20% from the January summit, as have main indices in Vietnam and the Philippines. The team of Asia EM equity strategists at Morgan Stanley recently downgraded China to Underweight while upgrading Australia to Equal-weight from Underweight.

Their motivation leaves little to the imagination: "We see these calls as defensive in a bear market".

Equally important, perhaps, is why Morgan Stanley refuses to lift Australian equities to Overweight: a downturn in housing activity and specific sector problems for Australian banks have the potential to ignite a domestic credit crunch, with negative ramifications for everything linked to domestic consumer spending.

If it were up to Morgan Stanley, investors domestically should seek exposure to energy stocks, USD earners, selected bond proxies and some defensive industrials.

Admittedly, not every strategist out there is equally as unenthusiastic about the outlook for the Australian economy, and by extension the Australian share market, as is Morgan Stanley. Tony Brennan, strategist at Citi, for example, predicts the ASX200 will close this year at around 6500 (+4.5%), to then move further up to 6650 by mid-2019.

Maybe the underlying message for investors remains the same: don't get too carried away by current outperformance for Australian equities. A higher oil price is not a one-way, risk-free blessing with many industrial companies non-discretionary consumers and with rising fuel costs simply adding more pressure on household budgets.

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Short term aside, I remain of the view prospects for the Australian share market will ultimately be defined by international developments and here, one has to conclude, the outlook looks increasingly challenged and uncertain.

A higher oil price is yet another threat to the global synchronised growth story that in 2018 is increasingly becoming more and more de-synchronised. Forward indicators for global trade are indicating broadening deceleration. Growth in a number of countries has underwhelmed in recent months. A similar case can be made for economic momentum in China and the USA-post Q2 which is likely to show up quarterly GDP growth well-above trend, but likely the peak for this year, and beyond.

These growing concerns only add to subdued economic signals for the Australian economy as well; last week's private credit growth data being a firm case in point. The update revealed private credit growth in Australia has now weakened to a four-year low of 4.8% year-on-year growth.

Equally important, Australia's household debt-to-income ratio has now risen to an all-time record high of 190% while at the same time, due to falling house prices (eight months in a row), household wealth fell by -0.4% in Q1; the largest fall since 2011. While, admittedly, this fall follows a surge to a record level of household wealth at $10.3trn in Q4 2017, UBS economists correctly remind us all the change in wealth is what drives the household savings ratio, not the actual level.

If history repeats itself, we should see underwhelming household consumption numbers in the months ahead.

Soon we might be witnessing a national debate as to why exactly did the Reserve Bank (RBA) remove the sentence from its May board meeting minutes stating "more likely that the next move in the cash rate would be up, rather than down"?

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As indicated by the quote on top of today's Weekly Insights, US equity strategists are increasingly of the opinion Trump's belligerent anti-open trade agitations are the opening chapter for more protectionism, more retaliation, and more international conflict instead of simply Art of the Deal negotiation tactics.

Now add further tightening from the Federal Reserve, a potential peak in US corporate earnings growth, rising wages, rising inflation, a rising US dollar and is it really a surprise US equity markets (S&P500) appear to have peaked five months ago?

GaveKal's Louis Gave formulated it as follows on Monday: "Year to date, investors have lost money on US investment grade bonds, on emerging debt, on US treasuries, on European bonds, and on pretty much every major global equity market. In recent weeks, only US small caps, US tech stocks, US junk bonds, and oil have made new highs.

"The global equity bull market is increasingly looking like the German soccer team: old, tired and getting slow, having reached its peak a while back.

"Putting it all together, it seems that unless the coming reporting season sees earnings hit out of the park, global equity markets are likely to deliver a lackluster summer. In that case, maybe the best thing to do over the coming months will be to reduce portfolio risk and head to the beach!"

At the very least, I think it's time to stop looking at the blue sky and start focusing on the potential downside.

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