Oil prices have soared by around 70% since last June. At around $77 per barrel, Brent crude has been driven to its late-2014 levels. The increase was caused by a combination of greater global demand, supply cuts by the Organisation of the Petroleum Exporting Countries and geopolitical disruption, such as President Donald Trump withdrawing the US from the Iran nuclear deal.
Traditionally, if oil prices are rising on the back of strong global demand, risk assets should be supported. However, if oil price gains are caused by production constraints from geopolitical tensions – such as the US sanctions on Iran – the resulting pick-up in inflation and hit to growth will be negative for risk assets. It may be a little surprising, therefore, that the latest disruption to commodity markets has garnered minimal equity market reaction.
One convincing reason is that there are doubts that Iran’s oil exports will be reduced meaningfully. Much of Iran’s oil is sold to China, India and Turkey, all of which are likely to ignore US sanctions, while Germany, France, the UK and Russia have all said they will not follow the US’s path. Saudi Arabia has already indicated that it will look to soften any production losses by increasing its own output, so global stock levels may not drop materially.
Another explanation is that the impact of rising oil prices on the US economy has changed in recent years. According to Bloomberg Economics, a typical rule of thumb was that each sustained $10 per barrel rise in oil prices would reduce US GDP by 0.3%. But thanks to the boom in shale oil, the US is now a significant producer and it should instead enjoy a windfall as prices rise.
The pessimist in me still sees negatives. For example, some estimates suggest the 15% rise in oil prices since the start of the year has offset around half of the boost to US growth from the corporate tax reform. If rising oil prices continue to feed into inflation expectations, the Federal Reserve may be forced to tighten policy more aggressively.
These latest developments have affected sentiment towards emerging markets negatively. Yet the higher oil price can have very different effects from country to country. Those that rely heavily on imported oil (such as India and China) will be pressured, while emerging market oil-producing nations such as Saudi Arabia, Nigeria and Colombia could be winners. The main problem for the winners is that emerging markets still tend to move together. Disruption in a commodity-importing region such as Asia threatens to drag down other emerging market regions with it.
On that basis, would I recommend shifting out of emerging markets? No. I am doubtful that oil prices will be sustained at this level. But if they are, I will be worried. I consider rising oil prices to be the most significant tail risk to the global economy and, as a result, to the positive outlook for risk assets in 2018.
Seema Shah is Global Investment Strategist at Principal Global Investors. This article first appeared on the Short and Sharp blog.