The Hindu Business Line : Bullish on crude, bullish on bonds

THE price of crude oil has retreated. It is a healthy 7 per cent retracement. NYMEX light crude price has dropped from $55 a barrel to around $51. Previously, it declined nearly 17 per cent when West Texas crude oil price dropped from $49 to $42 in September. Such corrections are very healthy and a normal feature of a bull market. Oil is headed higher. It escapes most people that crude oil is above $50 still. As with past economic crises, there is a state of denial in most investors' and policymakers' minds about oil. Much of the increase in oil price is attributed to speculation.

The magnitudes attributed to hedge funds and speculators are only directly proportional to one's imagination. There is an unwillingness to grasp the issue of how much oil there exactly is below the ground in OPEC, particularly in Saudi Arabia and how much of it can be easily extracted. Without finding the answers to it, it is hard to conclude that the recent oil price spike is all the work of speculators. I reckon that the world is in for a crude shock in the year(s) ahead. (Readers should regularly download the newsletters from www.peakoil.net and form their own conclusions.)

Despite my bullishness on oil, I remain an optimist that inflation would remain largely contained, not just in the US. Bill Gross, the well-known global bond fund manager in PIMCO, wrote a very persuasive piece (his October Monthly Investment Outlook: http://www.pimco.com/LeftNav/Late+Breaking+Commentary /IO/2004/IO_Oct_2004. htm) on how America is massively cooking its inflation numbers. Some 46 per cent of the items that go into the calculation of the consumer price index are adjusted for quality improvements that reduce the reported inflation rate. This, according to him, enables the Federal Reserve keep interest rates low and thus blow asset bubbles. As for America, he does have a persuasive point.

Such methods when applied to calculation of unemployment, pension benefits, does rob the recipient of money. It reduces workers' ability to extract wage revisions commensurate with the actual nominal charge on their wallets. Further, it overstates or flatters America's economic performance compared to Europe. But these are different issues.

For investors, it is important to remember that had these adjustments not been done, the official tolerable inflation rate range would have been from 2-4 per cent and not 1-3 per cent. Thus, the current inflation rate (for figures that strip out quality adjustments, please see Bill Gross' article above) would still be considered low. Further, the inflation rate — where such quality adjustments are not employed — in Canada, Australia and the Eurozone remains contained too. Just see the latest annual inflation rate for these `countries' in the Table:

In all the above countries/regions, the inflation rate has trended down in the course of this year rather than moving higher. Core inflation measures (that exclude food and energy prices from the total) are even lower, indicating the absence of pass-through from higher energy prices to other portions of the economy.

In my view, the reasons are obvious: Global excess capacity prevails, wage pressures are subdued and there is worker uncertainty. The issue of worker insecurity is crucial to understanding the prevalence of asset price inflation and the absence of consumer price inflation.

Further, let us remember that there is inflation except in consumer prices. It was there in stock prices and it is there in real estate prices now. The absence of consumer price inflation has further weakened the bargaining power of the workers and hence contributed to the inflation of asset prices. It is a self-reinforcing mechanism and the issues transcend this little note on financial markets. As long as central bankers remain indifferent to asset price inflation, consumer price inflation will remain subdued. It is a `class' issue and it shows no signs of turning in favour of workers and hence there is little threat of consumer price inflation.

The chart shows the investment/current profits ratio in America. In the height of the investment boom in the 1990s, private non-residential investment was at 350 per cent of GDP. Since then, investment-spending to profits ratio has drastically declined even as profits have surged since the end of recession in 2001. The current investment/profit ratio is well below the average of the last two decades (green line). The inference is that the capacity created in the 1990s is yet to be worked off.

Further, with so much capacity created in manufacturing in China and with companies discovering outsourcing and call centre opportunities in India and elsewhere, there are avenues to keep costs down. Further, there is no sign, as yet, that the scourge of terrorism and waning economic growth prospects have reversed globalisation and encouraged protectionism.

Therefore, if the crude oil price rises in the coming year (as is very likely), it is bound to drag down economic activity rather than stoke consumer price inflation. Therefore, those who are bullish on crude oil should be bullish about bonds too!

(The author is founder-director, Libran Asset Management Pte Ltd., Singapore. The views are personal. Address feedback to van@libranfund.com)