Last March 2, Wall Street plunged 1.5% as the spike in oil prices is perceived to derail any economic recovery in the making. At $97 oil for the Nymex, Bernanke said gains in oil prices were unlikely to roil the U.S. economy, although if oil prices remain high, that could stall growth and boost inflation. Yesterday, March 5, Wall Street ignores a very positive jobs data showing 192,000 jobs created, and their index instead sank almost 1% as crude continued to rise 2% on Middle East North Africa (MENA) worries and tension. This cycle of discontent and uprising is now continuing in Iran, Bahrain, Yemen, Oman, Mauritania, Jordan, Algeria, Kuwait, Sudan, Syria, Morocco, Palestine, and even unknown DJIBOUTI. Even Iraq that has had no Saddam already for the longest time is now being plagued by protests. Saudi Arabia and Qatar have their scheduled Day of Rage protests next week.
First, let us take a look at the direct effect on our home country Philippines, whose Overseas Filipino Workers (OFWs) make up a big chunk of our GDP in the form of remittance:
Remittances from the Middle East alone account for about 16% of the total money sent home by OFWs.
“Sa BSP figures 16% pero maaring mas malaki pa dahil yung iba dinadaan ang remittance through US (BSP figures say 16% but this could be bigger since some OFWs in the Middle East remit money through the US),” said Luz Lorenzo of ATR KimEng.
Lorenzo added that even before the unrest in the world’s key oil-producing regions began, remittance growth was already expected to slow down to 3% in 2011. In 2010, money sent home by OFWs grew 8.2% to $18.76 billion, a record high.
The central bank, however, noted that remittances from these strife-torn countries only account for about 2% of the total money from OFWs.
The main sources of remittances from the Middle East — Saudi Arabia ($1.5 billion), the United Arab Emirates ($775 million), and Qatar ($247 million) which collectively account for 87% of OFW money from the region — are currently not experiencing tension.
Data showed that the Middle East accounted for about 16 percent of the total OFW remittances last year. Remittances from the Middle East posted a double-digit growth of 11.2 percent to $2.96 billion last year from $2.66 billion in 2009.
More than half or $1.644 billion came from Saudi Arabia followed by the United Arab Emirates with $776.3 million, Qatar with $248.8 million, Bahrain with $167.28 million, Kuwait with $106.5 million, Israel with $67.3 million, Oman with $66.76 million, and others.
American counties accounted for 52 percent of the total remittances last year with $9.98 billion followed by European countries with 16.9 percent or $3.18 billion, and Asian countries with 12.6 percent or $2.36 billion.
The figures suggest that a scenario of reduced remittance from the Arab countries alone won’t cause our economy to shrink adversely, but rather the domino cycle effect of inflation that may derail global growth may be a bigger cause for concern.
We also researched on some ideas of research houses on their outlook on the effects of high price of oil on the Asian and even global economy.
Macquarie Securities noted for Japan:
We disagree with the view that deflation means Japan is the one country to benefit from higher oil prices. In the previous commodity boom, profits peaked in 1Q07 and domestic demand in 2Q07 as higher commodity prices pushed the economy towards recession well before the Lehman’s collapse.
Masamichi Adachi, economist at JPMorgan in Tokyo, reinforced the point:
Some commentators argue that the rise of commodity prices is welcome in Japan, which is suffering prolonged deflation. We disagree with this view. While the rise in food and energy prices may increase households’ inflation expectations, it does not mean that they can expect higher wages in the future. Actually, in a deflationary environment with considerable slack, the opposite will likely happen as the profit squeeze will weigh on wages, further restraining labor income and consumption. The deterioration in the terms of trade—resulting from a rise in import prices and a fall in (or flat) export prices—may be the drag on domestic demand, which is still sluggish and fragile.
On the broader question of the impact of oil price spikes on Asia, Macquarie says the impact on Asia would come through a variety of channels, it adds:
A supply shock to oil prices would affect Asian economies through two basic channels. It is different from a demand-driven rise in prices, which tends to have some self-correcting elements. First, there is a terms-of-trade shock that depresses demand in oil importers via an income transfer to oil producers and this hurts global demand as the producers tend to have a relatively low propensity to spend their windfall gains.
There is also the risk of an inflation shock. This is particularly the case in lower income economies where fuel has a higher weight in consumer spending, and which are institutionally more prone to second-round effects.
Most of the region would be hurt through the terms-of-trade effect… Even the impact on the energy-exporting economies is equivocal, as fuel subsidies hurt public finances…
Morgan Stanley argues, that this time, it’s different, economies won’t be that much adversely affected:
for two broad reasons. First, oil prices constitute wealth redistribution, not wealth destruction. And second, this time is different: as things stand, we think that the current oil shock is unlikely to harm growth much.
Higher oil prices redistribute wealth rather than destroying it. From a global perspective, higher oil prices do not mean that wealth is destroyed. Rather, it is redistributed – from net oil importers to net exporters (see below on The Effects of Oil Price Shocks). While this wealth transfer can be substantial, much of it is, over time, recycled back into net oil-importer economies:
• Oil exporters will spend some of their newly gained oil wealth on imports from net importers; hence, increased import demand replaces some of the domestic demand lost due to the wealth transfer;
• Oil exporters will also purchase assets in net importer economies, providing support for asset markets there.
Even so, oil shocks have always been redistributive – yet arguably they have done considerable damage to the global economy in the past. The 1970s, when oil price spikes preceded two successive recessions, are held up as the prime examples of the harm that oil can do to the economy. So, it is tempting to look at the effects of previous oil shocks in order to infer the consequences of the current one. We would urge caution, however, as all else is not equal. Many things are different this time, so a given increase in the price of oil should be less harmful now than it would have been in the 1970s
The Economist cites a positive effect that may come out of all this: At its worst, the danger is circular, with dearer oil and political uncertainty feeding each other. Even if that is avoided, the short-term prospects for the world economy are shakier than many realise. But there could be a silver lining: the rest of the world could at long last deal with its vulnerability to oil and the Middle East. The to-do list is well-known, from investing in the infrastructure for electric vehicles to pricing carbon. The 1970s oil shocks transformed the world economy. Perhaps a 2011 oil shock will do the same—at less cost.
Nouriel Roubini examined in a recent piece, the economic costs of MENA unrest extend far beyond the region, with rising commodity prices the most significant linking factor.
A further increase in oil prices would pose a significant downside risk to global growth. We expect demand destruction for fuel products to occur at lower oil prices than in 2008, as U.S. and EU consumers are more stretched. Fuel importers will suffer from higher prices, and global central bankers will face a more difficult job in setting policy. Countries like Turkey and South Korea with extensive goods and services exports to MENA countries could face two challenges from the region’s disruption: a stall in their projects with the countries and a deterioration of external balances from an increase in oil prices.
Beyond food and fuel security risks, the waves of unrest are washing up on the European continent in the form of increased numbers of migrants to southern EU nations. Already, Italy has reported an increase in Tunisians in Lampedusa, and some of the 100,000 Libyans flooding into Tunisia and Egypt may well try to make their way north. An increase in illegal migrants and refugees could stress the broader EU, which is still suffering from high unemployment rates and fiscal austerity.
The global economy can probably withstand a 10 or 15 percent rise in oil prices, but anything more than that could threaten the recovery. (That part of the article was published in the Middle of February, and oil prices have risen over 15% since then). Roubini says that if prices crested $100 and stayed there for a while, it would cut into global consumption and GDP growth, which could lead to a double-dip recession in some countries. If political upheaval actually interrupted the flow of oil, the effect would be more abrupt. It wouldn’t have to be a permanent loss of oil, even a temporary loss over six or 12 months would be enough for prices to rise very rapidly. The impact on the world economy would be significant.
Most economists don’t see that happening. Roubini predicts that oil prices will stay around $90 per barrel in 2011; forecasting firm IHS Global Insight predicts prices of $91. And the Saudis have recently suggested they’d pump enough oil to keep prices closer to $80. But those very reassurances from the economic establishment could make price spikes even more destabilizing if something unforeseen happens.
Scott Minerd, Chief Investment Officer, Guggenheim Partners, LLC wrote at hedgefund.net, a very interesting and comprehensive picture:
The unification of Germany in late 1990, for instance, led to the European currency crisis in 1992-1993 and essentially plunged the entire continent into a deep recession. Similarly, the 1991 collapse of the Soviet Union was followed by a severe recession and hyperinflation.
History teaches us that the revolutionary road is lined by economic shocks and currency instability. As the events play out in the Middle East and North Africa, I believe the turmoil in the region will perpetuate an economic domino effect that may result in dramatic shifts across the investment landscape over the course of the next year.
The Global Cost of Turmoil: Higher Oil Prices
As we have already begun to see, the mere threat of a disruption to the world’s oil supply has caused the price of crude oil to spike. The extent and duration of the spike in oil prices will depend largely on whether the threat extends beyond smaller oil producers like Libya, Algeria, Yemen, and Bahrain, and into larger players like Saudi Arabia and Iran. Keep in mind that oil prices spiked 15 percent on the perceived threat that Libya’s production of 1.6 million barrels per day might be in jeopardy. Imagine what may happen to prices if investors perceive the possibility of an interruption to Iran’s production of 3.7 million barrels per day, or Saudi Arabia’s 8.6 million barrels per day.
In terms of how high crude oil prices may rise, the summer of 1990 may provide some perspective. During the early stages of Operation Desert Storm, crude oil prices rose 141 percent over a three-month span. It was another five months before prices returned to pre-crisis levels, which meant that for more than eight months oil prices were, on average, 40 percent higher than pre-crisis levels.
If we apply a price appreciation experience similar to the Gulf War in 1990 to the average crude oil price one month prior to the protests in Egypt (approximately $90 per barrel for sweet crude oil futures on the NYMEX), we arrive at oil reaching as much as $215 per barrel. If we apply a lower percent increase, say the average increase of 40 percent during the 1990 conflict, crude oil would still exceed $125 per barrel. With crude oil futures currently trading around $98 per barrel, this means it would be possible to see oil prices rise another 25 percent increase from present levels. Short of a threat to Iran or Saudi Arabia, oil at $200 per barrel is unlikely; however, as the democracy movement spreads across the MENA region, I believe there is a very real prospect that crude oil prices could hit $125 or higher.
Higher Energy Prices Mean Pressure on Emerging Markets
If energy prices linger at such elevated levels, the next domino will be heightened inflationary pressures around the world, but particularly in the emerging markets. Central bankers in Brazil, Russia, India, and China (the “BRIC” countries) are already wrestling with runaway food prices. Surging energy prices are likely to trigger even tighter monetary policy decisions in the near term. The hawkish European Central Bank could even be convinced to move toward a rate hike as well.
But of all the economies impacted by higher energy prices, China may be in the worst position. Recently, China surpassed Japan as not only the second largest economy in the world, but also the second largest consumer of oil in the world. The possibility of a sustained, dramatic increase in energy prices should finally convince the People’s Bank of China that it has a significant inflation problem and is meaningfully behind the policy response curve. With inflation already at 4.9 percent but real interest rates at -1.9 percent, China is facing the triumvirate of price pressures: food, wages, and now energy.
But China is not alone. The other BRIC countries — Brazil, Russia, and India — also need to take dramatic policy measures to cool off overheating markets and fight inflation. We’ve already seen this in Russia, where a surprise rate increase was announced on February 25. This surprise move helped lift the ruble to its highest level in more than two years. Across the emerging markets, exchange rates (including the Chinese RMB) may be valued significantly higher to quash domestic inflation and calm the growing social unrest that has resulted from rising food prices.
Looking ahead, I believe restrictive monetary policy will lead to economic slowdown in the emerging markets in 2011. Since it’s seldom a good bet to fight against central banks, emerging market equities are not the place to be for the next few quarters. For investors looking at these markets, the next entry point should become apparent once there has been a material increase in interest rates and commodity prices begin to trend downward.
Cooling in the Emerging Markets Grinds on Europe
Any economic slowdown in the emerging markets will be especially painful for global economies that rely on exports to those markets for their livelihood in 2011. The prime example of this is Germany, the one economy that must remain strong for the sake of Europe.
Fueled by emerging market demand for autos, industrial products, and machinery, German exports to the BRICs rose 37 percent in 2010. This growth added as much as 1.1 percentage points to Germany’s remarkable 3.6 percent GDP growth for the year. If Germany isn’t able to expand its exports to the BRICs, which is entirely possible given last year’s robust output and the potential economic cooling of the emerging market economies, then Germany’s GDP could fall short of expectations by as much as a half of a percentage point.
Last year, when the German economy was humming along at 3.6 percent, Euro Area GDP was a scant 1.7 percent. In 2011, the economies of Greece and Portugal are projected to contract. Ireland and Spain teeter on the verge of recessions as well. The European Commission is already projecting German GDP to fall to 2.2 percent in 2011. If German GDP falls to below 2 percent, which I think is highly likely, economic growth for the Euro Area will likely dip below 1 percent, or possibly begin to contract. This means the Euro Area could find itself on the brink of another recession and the European Central Bank would be forced into accommodative monetary policy.
The Ultimate Beneficiary: U.S. Markets
After all these dominos fall, global investors will likely find themselves in a world that looks like this: the Middle East is highly unstable, emerging market economies are slowing, and the crisis in Europe has been exasperated by shrinking exports, leading to a decline in the value of the euro.
Against this landscape, the U.S. economy and dollar-denominated financial assets will look increasingly attractive on a relative value basis. By the second half of the year I expect to see a rebound in the dollar, lower bond yields, and the outperformance of U.S. equities relative to Europe and most of the emerging market countries, with the possible exception of Russia. The flight to safety play will also be good for gold prices, which continue to be in a generational bull market despite the recent consolidation (which I view as healthy).
Going Back to the First Domino
Looking back to the beginning of economic domino effect, it’s natural to think of the turmoil in the MENA region as the precipitating event — the hand that tipped over the first domino. But what may be most ironic about this entire scenario is that the dominos falling across the globe, from the Middle East to Asia and then Europe, ultimately end up back in the United States. I say “back” in the United States because the first domino that set these events in motion was actually the Federal Reserve’s policy of quantitative easing.
By printing almost $2 trillion dollars and using them to buy assets, the United States created a rising tide of liquidity that has lifted all asset prices, including commodities, and more specifically agricultural products. Just as chronic food shortages were a major catalyst in the 1991 revolution in the Soviet Union, rising food prices have been a catalyst for the social unrest in the Middle East and North Africa, and it even appears to be spilling over into China under the banner of the Jasmine Revolution.
Regardless of who’s to be blamed (or credited, depending on your perspective) for prompting the social unrest that has swelled into waves of democratic revolutions washing over the Middle East, the moral of the story for investors is that the U.S. financial markets should prove to be one of the most attractive places to invest in 2011.
The situation in MENA leads me to believe that things will inevitably get worse, and that opposition forces in neighboring countries will seize this opportunity and do their best in ousting incumbent leaders and push for reforms. This doesn’t mean that they will succeed, but their effort and uncertainty of the outcome and duration may indeed increase the price of oil further. The long term effects (like seeking alternative energy sources and developing low cost green vehicles, more democracy and rights for the MENA citizens) will definitely be good for countries across the globe, provided that the situation will not deteriorate into a worst case scenario of World War 3.