- A high oil price has in the past been a warning of low returns on mining and emerging market equities.
- Investors are quicker to price in the good news of high oil prices (that they are a sign of stronger growth) than the bad – that lead depress economic activity.
The oil price has risen to almost a three-year high, prompting the question: what is this telling us?
In theory, of course, the answer is: nothing. The efficient market hypothesis tells us that all information – especially about something as obvious as the price of oil – should be quickly embodied in the price of all assets. If so, then a high oil price has no investment implications.
But of course, the efficient market hypothesis is only that – a hypothesis. Hypotheses need testing. And in this case, the test has been failed. Back in 2007 Tilburg University’s Ben Jacobsen and colleagues found that, between 1973 and 2003, higher oil prices had led to lower returns in many national stock markets the following month. Oil prices have had a message for investors, and it has been bad news.
Our story, however, cannot end here. Investors sometimes learn from academic research and so remove deviations from efficient market theory, as John Cotter and Niall McGeever at University College Dublin have shown. In this case, however, they seem not to have done so. Since the end of 2003 there has also been a negative correlation between the oil price and returns on the All-Share index the following month.
Granted, the correlation has been low – only minus 0.14. And it has been of only marginal significance, either statistically or economically: a $10 per barrel higher oil price has led on average to monthly returns being 0.2 percentage points lower. Even so, this is evidence against the pure efficient markets hypothesis.
You might think such a relationship is too weak to be a basis for an investment strategy. I agree. There are, however, segments of the market where the link is strong enough to matter.
For mining stocks, the correlation between the price of Brent crude and price changes in the following 12 months has been a hefty minus 0.46 since January 2000, with each $10 per barrel higher oil price leading on average to annual returns being 5.2 percentage points lower. For emerging markets in this time, each $10 per barrel higher oil price has led to annual returns (in dollar terms) being 2.9 percentage points lower. And there have also been significant negative correlations between the oil price and subsequent annual returns on oil and construction stocks and indeed in changes in the oil price itself.
A high oil price, then, is a warning to be cautious about big chunks of the market.
What’s going on here is straightforward. Rises in the oil price are symptomatic of a good thing and causal of a bad one. They are a symptom of stronger growth, which is why rises in the oil prices are usually accompanied by rises in equities generally. But they cause slower growth, because higher oil prices reduce the real incomes of companies and consumers, leaving them less to spend on other things.
However, investors pay too much attention to the good news of rising oil prices and too little to the bad. The upshot is that as the bad news becomes evident in the months after an oil price rise cyclical stocks such as miners, construction and emerging markets fall back.
One other fact corroborates this story – that high oil prices tend, albeit weakly, to lead to above-average annual returns on gilts, pharmaceuticals and food producers. This is consistent with investors shifting out of cyclicals and into defensive assets as they belatedly realise that higher oil prices cause weaker economic activity.
It is also consistent with the tendency for a high oil price to lead to a falling one over the following 12 months. Since 2000 each $10 per barrel higher price has led on average to prices falling 6 per cent over the next 12 months. This is basic economics. A high price of anything causes customers to economise on it and suppliers to increase production, both of which cause the price to fall.
None of this is to say that the oil price is so high as to presage disaster. At $75 per barrel it is only $11 per barrel above its post-2000 average. And the links between it and subsequent returns on cyclical stocks, whilst significant, are not huge. And of course, it is always possible that what has been true in the past will not remain true in the future.
What it is telling us, though, is to be cautious about sectors such as miners and emerging markets. One of the mechanisms that cause economies to be cyclical is that upturns raise commodity prices and so lead to weaker growth. Cycles, remember, have downturns as well as upturns.
