Discussions surrounding oil pricing in currencies other than the dollar are not new. Recently, these conversations have gained momentum, fueled by the dollar’s depreciation in foreign exchange markets and the challenges it poses to oil-exporting nations. However, it is quite rare for high-ranking OPEC officials to address this issue openly. That changed recently.
On Friday, OPEC Secretary-General Abdullah al-Badri mentioned in an interview with The Middle East Economic Digest: “Perhaps we can consider pricing oil in euros. It’s feasible, but will require time,” as reported by AFP. He further elaborated in comments to The Guardian: “In oil exchanges in New York, Singapore, or Dubai, the euro or yen can be utilized. However, as long as the final settlement occurs in dollars, the pricing remains dollar-based. The dollar took over 50 years and two world wars to establish its dominance. Today, we see another strong currency entering the market—the euro.”
While discussing the possibility of altering oil pricing is straightforward, implementing such a change is a complex challenge. Currently, the global oil market predominantly prices crude in dollars, and as al-Badri noted, transforming the existing financial infrastructure is a long-term endeavor—potentially spanning years to decades. Nonetheless, the incentive to pursue this change is growing, and with determination, progress can be made.
While the ongoing adjustment of risk in capital and commodity markets may be daunting, it is a natural and regular occurrence that often unveils new opportunities, albeit accompanied by fresh, unforeseen risks for astute investors. Periodic rebalancing of asset allocations is generally advisable, especially these days given the heightened volatility in some asset classes and a prevailing sense that unusual risks may be lurking just out of sight. This situation serves as a timely prompt to reassess the correlations between stocks, bonds, REITs, and commodities, especially considering how recent market upheavals have reshuffled the dynamics between these asset classes.
For simplicity, our analysis focuses on correlations from a U.S. stock market perspective. Although examining these correlations through the lens of bonds, REITs, or commodities is beneficial, our examination today will concentrate solely on how correlations have shifted concerning U.S. equities as represented by the Russell 3000 index, which provides a broad assessment of the market.
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Indices used in calculation: Russell 3000, Lehman Bros. Aggregate Bond, DJ Wilshire REIT, DJ-AIG Commodity, iBoxx High Yield, Citigroup Non-$ World Govt (un Hdg, $), MSCI EAFE, MSCI EM
Before diving into the analysis, let’s clarify a few terms. The accompanying chart illustrates rolling 36-month correlations based on monthly total returns for the respective markets. For instance, the correlation between U.S. stocks and commodities for January 2008 is derived from data reflecting the preceding 36 months of total returns for each asset class. Correlation gauges the relationship between two data series—in this case, monthly total returns. A correlation of 1.0 indicates perfect positive correlation, meaning the two markets behave identically or are highly similar. Conversely, a correlation of 0.0 denotes no correlation, while -1.0 represents perfect negative correlation. Consequently, a strong case exists for diversifying portfolios by incorporating asset classes with low or negative correlations. While the specifics of portfolio construction are complex, this principle holds significant merit in our view.
The topic of peak oil continues to spark debate and remains unresolved. Evidence supporting this theory often draws from the recent bull market in crude oil prices, leading some to assert that global production may have hit its maximum capacity.
Optimists argue that technological advancements will come to the rescue, through either discovering new reserves that could offset declining outputs from aging fields or improving oil recovery rates from wells at risk of depletion.
The larger picture remains uncertain and might stay that way for years. Meanwhile, a wealth of data exists for scrutiny. For instance, the highest recorded global crude oil production occurred in May 2005 at 74.3 million barrels per day (bpd), as shown in our chart below, according to figures from the U.S. Energy Information Administration. Only three months have seen global production surpassing 74 million bpd, with last October producing 74.1 million bpd, slightly lower than the peak in May 2005.
Whether that previous high will be surpassed remains uncertain. Questions linger regarding the precision of the EIA’s data, given the challenges of consolidating such a complex system as global oil production into a single figure. Regardless, interest in production updates remains high, with expectations shaped by how closely last October’s figures approached the May 2005 record. Presently, the EIA’s monthly production stats extend to October 2007, with a November report anticipated soon. As global attention shifts to oil supply, demand dynamics remain much clearer. The story here continues to reveal steady growth.
Recent discussions about market bubbles have raised various predictions about where one might occur next. Some analysts point toward energy, while others suggest concerns surrounding gold. Here’s our nomination: bonds.
Our focus is the widely-followed 10-year Treasury, a benchmark for both U.S. and select international debt markets. The evidence supporting our bubble hypothesis is presented in the chart below, which captures the daily closing yield of the 10-year Treasury over the past 40 years, culminating at last night’s close. It clearly illustrates the significant downward trending yields over the last 26 years. Since peaking at 15.84% on September 30, 1981, the yield on the 10-year has gradually dropped, with occasional increases.
As of yesterday’s close, the 10-year yield stands at 3.61%, a substantial 1200 basis points lower than the 1981 peak. Interestingly, this figure is not the lowest yield recorded recently; in June 2003, the yield fell to 3.20% during daily trading. Current conditions suggest that these low levels may be approached again, provided market sentiment allows. The fixed-income sector has continued to align with the Federal Reserve’s actions to lower rates, a trend that is not surprising given that declining rates have driven bond performance among the major asset classes. This explains why bonds have proved resilient, both relatively and absolutely, with the iShares Lehman Aggregate Bond ETF (AGG), for instance, achieving a 2.5% total return this year and 8.9% over the past 12 months. Even inflation-protected bonds and foreign bonds in developed markets have performed even better in those timeframes. Meanwhile, other significant asset classes have fared less robustly.
Tax policies remain an ongoing and highly relevant discussion, especially during an election year filled with major proposals regarding government programs. Government actions entail spending, leading to the inevitable question: Who will bear the cost?
In light of this, we offer a historical perspective on past tax policies. While the future remains unpredictable, the past is undeniably clear. As highlighted in the February issue of Wealth Manager, taking a retrospective view can provide essential context amidst the political rhetoric dominating conversations today. Emphasizing context often proves helpful, sometimes even refreshing.
After 52 consecutive months of job growth, January marked a notable downturn.
The Labor Department revealed a decrease of 17,000 non-farm payroll jobs last month, marking the first decline since August 2003. While 17,000 might seem minimal in a workforce of nearly 159 million, it’s noteworthy. A revision upward to a positive figure next month is possible; in fact, the initial report for December’s modest 18,000 increase was revised to a healthier gain of 82,000.
However, revisions cannot negate the downturn that appears to be gaining traction in the economy. The trend of job creation is clearly shifting downward in both one-month and one-year comparisons. Today’s figures indicate that warning signs are spreading beyond just the manufacturing sector.
The services industry, which comprises over 80% of U.S. employment, managed to create just 34,000 new jobs last month—a negligible increase against the backdrop of 116 million individuals working in the sector. This also represents the first instance of effectively flat service sector job growth since October 2005.
Asset allocation has once again emerged as a critical strategy for discerning investors, as evidenced by the performance metrics among major asset classes from January.
Last month, the return spectrum among major asset classes showcased a substantial difference of 14.1 percentage points. The top performer was foreign developed market bonds, yielding a total return of 5.2% in January, as represented by the PIMCO Foreign Bond (Unhedged) D mutual fund. Conversely, emerging market stocks took a hit, falling 8.9% as noted by the iShares MSCI Emerging Markets ETF.
The days of indiscriminate rising markets are behind us. The stakes linked to asset allocation and rebalancing have increased. With rising volatility and lower correlations among major asset classes, we expect this trend to continue.
As economic conditions evolve, risk appraisal and pricing will occur on an individual basis. Investors will become more judicious, weighing the outlook of bonds against stocks, domestic assets versus foreign investments, and commodities against equities, among other comparisons. This selective behavior had diminished from 2002 to 2007, but the current environment necessitates a more discerning approach.
It remains uncertain whether the bond market will continue to align with the Fed’s monetary strategies. However, from a broader perspective, the outlook appears positive, as our chart suggests. Both rates and spreads have significantly decreased, resulting in an upward-sloping yield curve.
Following yesterday’s cut, the federal funds rate is now at 3.0%, notably below the benchmark 10-year Treasury yield of 3.78% as of last night’s close. The decline in the 10-year yield has been both sharp and rapid, having peaked at 5.23% last June before falling nearly 150 basis points.
The Federal Reserve’s strategy to reflate the economy is clear, although whether it is the best approach remains up for debate. Such a substantial reduction in the fed funds rate usually does not happen so quickly, and the possibility of further cuts is still on the table. Reports suggest that the May ’08 fed funds futures contract implies expectations of an additional 50-basis-point cut, which would lower the rate to 2.5%.
Thus far, the bond market has responded positively to the Fed’s actions. This development is crucial; we can only imagine the tumult that would ensue if the Fed’s aggressive cuts resulted in widespread panic among bond investors. Instead, the bond market has largely exhibited confidence, as evidenced by the 2.8% increase in the iShares Lehman 7-10 Year Treasury ETF (IEF) this month alone. Since last June, this ETF has appreciated nearly 15%, which is remarkable given its classification as a low-risk asset under normal inflationary conditions.
The initial estimates for fourth-quarter GDP confirm what many had already suspected: the economy considerably slowed during the last quarter of 2007, posting a real (inflation-adjusted) annual growth rate of 0.6%, according to the Bureau of Economic Analysis. This is substantially lower than the robust 4.9% growth recorded for the third quarter.
The culprit for the slowdown? The residential real estate sector. The spending on new housing construction and related services fell by nearly 24% in the fourth quarter, adding to the downturn that followed a 20.5% drop in the previous quarter. Notably, to find a time when residential real estate investment contributed positively to GDP, one must look back to the fourth quarter of 2005. Since then, this sector has consistently yielded losses each quarter, and the cumulative effect is becoming apparent in the broader economy. The staggering 23.9% decline in housing investment in the last quarter of last year represents the most severe dip observed during this economic cycle and highlights the intensifying pressures on overall economic growth.
Despite the distressing trends in real estate, the broader impact remains somewhat contained, at least during the fourth quarter. Whether this continues remains to be seen. While consumer spending showed signs of slowing in the last three months of 2007, it still appears to be advancing. Unfortunately, the 2.0% increase in consumer spending is rather unimpressive compared to the past few years. Nevertheless, it’s noteworthy that consumer spending trends have been outpacing overall economic growth. Perhaps it’s worth acknowledging these small, albeit tenuous, silver linings.
Current economic reports can be impactful, often leading to a wave of commentary and influencing market behavior. While these updates sometimes mirror broader trends, they can also be clouded by statistical noise.
This notion is relevant in the wake of recent encouraging statistics on durable goods orders. It is challenging to ascertain whether this data is genuinely reflecting an upward shift or if it’s merely a short-lived blip. We can never be certain until time provides clarity. Yet, strategically-minded investors face a tight timeframe; waiting a year for answers isn’t feasible, nor is rushing to conclusions based on the latest numbers. A balanced approach involves considering a longer-term perspective regarding the overall economic cycle.
With that in mind, the chart below showcases the 12-month rolling percentage change in new orders for manufactured durable goods, right up to the December 2007 figures. Notably, new durable goods orders surged by 5.2% last month compared to the previous month. This increase marks the highest monthly growth since July, and substantial monthly gains of over 5% are relatively rare, occurring about 10% of the time in the last decade. Therefore, last month’s report should not be undervalued as it includes significant implications for future economic indicators.
However, this optimistic narrative must be tempered with a wider context. December’s positive figures do not alter the general downward trend visible over the past two years. Smoothing the volatility inherent in durable goods orders through annual comparisons illustrates a clear slowdown that seems to maintain its momentum. On a positive note, this decline appears mild when compared to past downturns in 2000 and 2001, which frequently saw annual drops in durable goods orders between 5% to 20%.
