It was the best of times, it was the worst of times, Dickens wrote in A Tale of Two Cities. One might say the same after surveying the outlook for the economy and the implications for investing.
There are numerous straws about that threaten to break the proverbial camel’s back. At the same time, there are a number of counter forces at work that may bushwhack the best- laid expectations of the pessimists for a time. Watching this back and forth, and trying to figure out when and where a tipping point will occur represents one of the more worthwhile areas of scrutiny for the intrepid investor.
On the aisle of optimism is the bullish prediction flowing from the most famous discounting mechanism, otherwise known as the stock market. Equity traders, bless their little hearts, just can’t help bursting with bullishness these days. Friday’s session was particularly exuberant, with the S&P 500 surging upward to its highest since early 2001. Indeed, the 1% climb on May 5 was anything but tentative. The stock market is hardly infallible. But if the steady climb in equity prices that’s prevailed for much of the past two years is misguided, it’s one of the more consistent and lengthy instances of imprudence on record.

Jumping on the bandwagon of optimism is European Central Bank President Jean- Claude Trichet, who says that “global economic growth remains strong and steady,” Bloomberg News reports.
There are, of course, counter arguments to that sunny disposition, as long-time CS readers can attest. But for investors interested in making money, dissecting the potential for risk and reward demands a judicious, objective summary of the full scale of what appears to be unfolding. So, yes, the list of encouraging reports favoring the vision of economic growth is plentiful of late, as we’ve documented over the past weeks and months. Meanwhile, the presence of positives doesn’t banish the existence of negatives, of which there is no shortage either. The forecasting challenge is figuring out how the two sides of light and dark interact.
The global economy, after all, is the most dynamic it’s been in generations, perhaps in all of history. Money flows effortlessly across borders of the leading economies, and something approaching free-market prices impact the value of goods and services and consumer decisions, governments, central banks and corporations. As a result, there is a constant feedback loop in place, a process that’s at once reactive and anticipatory.
Recognizing as much, one might wonder how the system will adjust in the coming weeks and months to what is arguably the primary threat to global growth, at least among the threats that we can see and prepare for (or dismiss) in the here and now. Oil prices, in other words, remain high, and stubbornly so.
Over the past two years, the price of a barrel of oil has roughly doubled, having closed at around $70 in New York trading last week. To date, the price ascent has come with relatively little fallout for the general economy, at least relative to what some might expect after studying the history of oil bull markets. Some say it’s different this time because the higher prices have come from rising demand rather than an artificial cutoff in supply. True, although eventually high oil prices are still high oil prices, and the laws of economics will prevail. As such, everyone has to ask themselves if the effects of high energy costs are any different in a supply-driven bull market vs. a demand-driven one.
In any case, while the global economy has weathered the bull market in energy so far, it would be foolish to think that the danger has passed. In fact, the dynamism of the economy is reacting as we speak, just not in sharp, obvious ways in the short term. Rather, the change is evolutionary and slow, but decisive nonetheless.
We could easily provide a laundry list of global economic shifts born of oil’s price rise that represent change in some material way, if not today then tomorrow. The question is, as always, timing and magnitude.
In any case, you may have noticed that oil-exporting nations are accumulating huge cash reserves that were formerly the stuff of dreams for many of these nations. The Economist reports that oil exporters’ current-account surpluses grew to $400 billion in 2005, up by four times from 2002 and on track to rise to $480 billion this year.
Piles of cash, of course, represent power, and power brings change. A quick example on the geopolitical front: Venezuela’s oil exports are funding the dreams and visions of socialism, as conceived by Hugo Chavez. Take note that Chavez has made it clear that he intends to do all he can to offer aid and comfort for energy exporters elsewhere in their efforts to nationalize energy operations and otherwise thwart the free market pricing system that’s built up over the years. The beneficiary du jour is Bolivia, which is moving ahead with nationalizing one of South America’s most strategic reserves of natural gas exports, in part thanks to pledges of funding from Venezuela.
Then there’s the issue of what kind of purely economic adjustments will come from high oil prices. Expecting the status quo to dominate is foolish. Although it’s hard to say exactly what’s coming, we can throw out some informed guesses, starting with higher inflation, if only marginally so. No sign of that yet, but even a small uptick from current levels could send shivers down the equity market’s spine, in part because stock prices have enjoyed such a potent run in recent years, and at a time when inflation has remained relatively quiet. If inflation were to prove itself viable at maintaining a 3-4% rate in the United States, the reaction from the Fed and the stock market would be less than subtle.
Meanwhile, it’s also prudent to expect that higher energy prices will squeeze consumer spending. There may be scant signs of fallout from this process so far, but there’s also a lagged effect from energy price shocks. That realization, combined with the slow but steady hikes in interest rates, will eventually conspire by delivering something less than edible for the equity market’s current appetite for risk. Again, timing and magnitude are the open questions.
We can also point to the dollar to project hopes and fears, depending on one’s bias. The buck is currently suffering its sharpest stumble in recent memory. The U.S. Dollar Index is at its lowest in about a year. Arguably, some (most?) of this is the adjustment from America’s massive and growing imports of higher-priced oil. A lower dollar raises the price of imports, including oil. Yet, in theory, this may help reduce America’s trade deficit, because higher-priced imports may eventually lessen consumer spending while promoting U.S. exports via lower prices when measured in foreign currencies.
But a falling dollar also has risks. If it falls too far, too fast, foreigners may be increasingly reluctant to funnel money into America, which has become dependent on such flows in recent years. Then again, slowing inflows imply higher interest rates if demand for bonds weakens via a conspicious absence of foreign buyers. Higher interest rates, meanwhile, may boost the dollar in forex markets.
The potential for a virtuous circle is always just around the corner. Timing and magnitude, Virginia, timing and magnitude.