David Joy — Chief Market Strategist, RiverSource Investments
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Has crude oil become this summer's "Jaws," circling just offshore, never far from investors minds, threatening to disrupt what had been a welcome recovery?
Summer vacations at the shore have never been the same since the movie's release in 1975. The fear of a shark attack, however remote, is always present in the subconscious of any swimmer who has seen the film.
On Thursday, there was a shark sighting for investors as oil spiked $5.49 a barrel. (Cue the "Jaws" theme music here.)
Normally, this might have scared investors out of the water, but it was such a nice day, with stocks rising two percent, that it was largely ignored. Then, on Friday, there was a full out attack, with a surge of $10.75 a barrel to a new high of $138.54. Stocks fell three percent in response.
The question is where do we go from here? Does the shark stick around and continue to terrorize beachgoers, or does it move on having had its fill? Does the price of oil subside after such a sharp advance, restoring calm to the waters, or does it continue to dominate the landscape and inexorably march higher toward well-publicized price targets of $150 a barrel, and higher? And who will be the brave souls willing to put their toes back into the water, and when will they know it is safe?
(Coincidentally, it was during the summer of 1975 that stocks were recovering from the Arab oil embargo of 1973-1974. In the 12 months following September 1973, stocks fell in excess of 40 percent. By the time "Jaws" opened on June 20, 1975, the market had recovered 49 percent from its low in October 1974.)
The higher price of oil was already a concern before the jump at the end of last week. The inflationary implications of persistently high prices accompanied by abundant liquidity have caused us to anticipate rising core inflationary pressures over the next 12 months. Higher prices are likely to both exacerbate this outcome, as well as to accelerate it. In addition, while the economy had seemed to adjust fairly well to the steady increase in prices, demand for gasoline has already declined and still higher prices at the pump were on their way even before last week's surge.
Will this new price plateau, if it is maintained, represent a tipping point for consumers, or will the adjustment process continue? What will be the response when gasoline reaches $5.00 a gallon?
While oil was the center of attention last week, by no means was it the only news of importance. A spike in the unemployment rate to 5.5 percent sent shudders through capital markets Friday as well. The yield on the 10-year Treasury note fell 13 basis points to 3.91 percent. The odds of a Federal Reserve rate hike in the fall receded as well.
However, the full employment report was not as bad as the unemployment rate would suggest. Together with prior months revisions, the loss of jobs was as expected and hardly indicative of a cratering labor market, while the length of the workweek was also in-line. It seems that there was a surge in the size of the labor force, apparently attributable to students ending the school year, which the Labor Department may not have adequately incorporated. If so, all else being equal, a readjustment downward in the unemployment rate might be expected next month.
Another significant development last week concerned the dollar. After having stabilized against the euro in recent weeks, the dollar fell back to 1.5777 from 1.5554 the previous Friday. The president of the European Central Bank said that it may raise interest rates soon to head off rising inflation pressures.
Whatever strength the dollar had derived from Fed Chairman Ben Bernanke's implication earlier in the week that it may be finished its easing was quickly dissipated. The weakness helped the MSCI EAFE index outperform its domestic counterparts with a decline of just 1.4 percent in dollar terms.
Lastly, Moody's said that it may cut the ratings on issuers MBIA and Ambac. The yield to maturity of the Bond Buyer 40 Bond index was virtually unchanged, ending the week where it began, at 5.13 percent, reflecting the view that the market had fully discounted the possibility.
There remains the concern, however, that a steeper-than-expected ratings cut could occur in which case additional selling pressure could emerge into an already weak municipal market.
Editors note: "Just when you thought it was safe to go back in the water" was actually the tag line for "Jaws 2," which was released in 1978.
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