Stock mar­kets have an oil con­ta­gion to deal with

The Pak Banker - - OPINION - John Authers

WHAT on earth? Last week, world mar­kets com­pounded their worst start to a year on record with a suc­ces­sion of dra­matic and ap­par­ently in­ex­pli­ca­ble dives, re­v­erses and re­bounds. It seemed wild and weary to me sit­ting in New York for the first two weeks of the year, and seems down­right crazy af­ter a bizarre week in Tokyo. That is only partly due to jet lag. Glob­ally, stocks - as rep­re­sented by the FTSE All-World in­dex - briefly dropped 20 per cent from last year's high. Oil con­tin­ued to sell off be­fore a huge per­cent­age bounce at the end of the week that left Brent crude just above the re­cently un­think­able level of $30.

In Ja­pan, the Nikkei 225 tanked by 6.6 per cent dur­ing the week, only to re­gain al­most all of it on Fri­day (Jan­uary 21) and end off only 1.1 per cent. There were many sharp re­v­erses, in­clud­ing a 4.3 per cent drop on Thurs­day af­ter­noon af­ter a pos­i­tive morn­ing ses­sion. The cat­a­lysts for the global tur­moil - con­fu­sion over China, and the oil price - should not have much of an im­pact in Ja­pan. It im­ports vir­tu­ally all of its com­modi­ties, and cheaper oil should be a straight­for­ward ben­e­fit. As it does not ex­port com­modi­ties to China, it has lit­tle eco­nomic ex­po­sure to its near neigh­bour.

In­deed, it in many ways com­petes against China. Con­fu­sion should be good news. Many of the cat­a­lysts for prob­lems with US eq­ui­ties also do not ap­ply. US com­pa­nies are en­dur­ing Ja­pan there are hopes that it is barely get­ting started. Yes, there are wor­ries about the di­rec­tion of eco­nomic pol­icy. The in­ten­tion to press ahead with rais­ing con­sump­tion tax from 8 to 10 per cent next year, af­ter the dis­as­trous re­cep­tion for the last rise three years ago, looks like a kamikaze mis­sion. But the Bank of Ja­pan is eas­ing, and will if any­thing in­ten­sify its eas­ing over the months to come.

The yen has strength­ened re­cently and is as strong against the dol­lar as it has been in a year. But the huge de­pre­ci­a­tion and im­prove­ment in Ja­pan's terms of trade trig­gered by the ar­rival of Shinzo Abe as premier late in 2012 re­mains in­tact. Of­fi­cials do not seem wor­ried. So how has Ja­pan lapsed into yet an­other cycli­cal bear mar­ket, within the drawn-out sec­u­lar bear mar­ket that has now lasted 26 years? And what can ac­count for volatil­ity on the scale seen this week? Traders are con­vinced that the prob­lem is a new form of con­ta­gion, from the oil price. Sov­er­eign wealth funds have been plac­ing huge sales or­ders.

They would have lit­tle choice but to sell eq­ui­ties. Re­search by Pre­qin shows that most have hold­ings in illiq­uid in­vest­ments such as in­fra­struc­ture and real es­tate, so in a hurry, it is eq­ui­ties that have to be sold. It also found that as­sets un­der man­age­ment by sov­er­eign funds de­rived from hy­dro­car­bons reached $3.44 tril­lion early last year - up from $1.94 tril­lion in the af­ter­math of the Lehman cri­sis. Any sig­nif­i­cant move to liq­ui­date such funds could have a huge im­pact on their most liq­uid as­sets - such as Ja­panese stocks.

Oil's lat­est leg down at the start of this year was largely un­pre­dicted, and may well have forced many such funds to make re­demp­tions. They might eas­ily have prod­ded mar­kets into jump­ing in the way they have done last week. Why sell Ja­pan? Be­cause they can. It is eas­ily the big­gest and most liq­uid mar­ket in Asia, and vir­tu­ally the only one where sell­ing in­volves tak­ing a profit rather than a loss. Ac­cord­ing to MSCI, Ja­pan had out­per­formed the rest of Asia by a third over the first eight months of last year.

So it looks alarm­ingly as though the events in Ja­pan point to a new form of oil con­ta­gion. It is pos­si­ble to ar­gue - as many sell­side bro­kers are do­ing - that if a sell-off is driven by fi­nan­cial fac­tors and not eco­nomic fun­da­men­tals, it is not so wor­ry­ing. It cer­tainly al­lows for big snap­backs when the oil price ticks up a lit­tle. But we should be cau­tious about such rea­son­ing. The oil price fall is grounded in real is­sues of over­sup­ply, not just spec­u­la­tive ex­cess. And mar­kets can cre­ate their own eco­nomic re­al­ity. Higher oil prices, back in the sum­mer of 2008, per­suaded the Euro­pean Cen­tral Bank to try a dis­as­trous rate rise on the eve of an epochal credit cri­sis.

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