Stock markets have an oil contagion to deal with
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.