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Boiling Point: What If Oil Hits $150 Again?

The recent spike in oil has caused a surge in media coverage, dredging up everything from comparisons to the oil shocks of the 1970s to the implications on global growth and stability. What I see is a clear example of the predicament the Fed finds itself in as it tries to reinflate the economy.

Chadd Bennett

The central bank's monetary-policy moves-first the cutting of short-term rates to zero and now the buying of longer-dated Treasury debt-are meant to cheapen credit costs in the hopes of reflating wealth-creating assets, stocks and real estate in particular. Real estate is still dropping these days, but stocks have cooperated thus far, rallying about 25 percent since September.

But, as Pimco's co-Chief Investment Officer Mohamed El-Erian has been pointing out, because the Fed only has these "blunt" instruments at its disposal, it inflates wealth-destroying assets as well, namely food and energy. I think we're reaching an inflection point when the inflation of wealth-destroying assets outweighs the benefits of the increase in assets like stocks.

Economic Impact

The true economic impact of high oil prices is a big topic of debate among economists. The consensus seems to be that a $10 rise in the price crude takes away 0.5 percent from economic growth in the year or two following that increase. Oil shocks , however, can have a much more potent effect, as the St. Louis Fed discussed in a paper in April 2008.

The Fed paper argues that capital spending by businesses can slow down not only because of the direct impact of rising oil prices, but also due to uncertainty surrounding the trajectory of prices.

In addition, capital and investment will often be reallocated away from the affected sectors to the "less affected sectors," which can also be costly. These two variables add downward pressure to real GDP growth. In other words, people's reaction to the prospect of rising oil prices can amplify the effects of high energy prices.

The paper came out a few months before oil spiked to its previous high of $147 per barrel in the summer of 2008. It's no stretch to assume that those high oil prices contributed to the stock market crash and rapid slowdown we saw going into 2009. Since oil prices are only 40 percent off their highs at this point, it's worth comparing today's economic conditions to those in 2008.

Fortunately, the U.S. economy is currently gaining momentum, and continues to surprise to the upside. New orders from the latest Chicago PMI number hit their highest level since 1983, and the Institute for Supply Management's data on both factories and services are strong.

However, in my mind, a key question remains:What is the price we are paying for this growth?

Consumer

Overall, it seems to me U.S. consumers are in worse shape heading into the current oil price spike than they were in 2008.

For example, unemployment in the U.S. was roughly 5 percent at the start of 2008 versus the 9 percent currently.

Over 6 million of the 14 million unemployed have been out of work for more than six months. Personal income minus transfer payments, such as unemployment benefits and food stamps - better signs of the true vitality of the consumer-is roughly $400 billion below where it was at the start of 2008.

Also, total U.S. household net worth at the end of the 2010 third quarter is roughly $10 trillion, or 15 percent, below where it was going into the market meltdown.

Financial System

Another important aspect of the 2008 economic context, that is relatively less dangerous today, is the health of the banking system. In summer of 2008, the financial system was already scrambling for both liquidity and capital-although quietly-as it took measure of losses from mortgage-related assets and general consumer debt continuing to mount.

The uncertainty of the fates of Fannie Mae and Freddie Mac, questions about the durability of the investment bank business model, and a general slowing of economic momentum also played major roles.

While the collective magnitude of the threats are arguably less today than they were then, the head winds for the banking system in Europe could be enough on its own to destabilize the global financial system. Portuguese bond yields hit all-time highs this week, as have as Greek sovereign CDS spreads as the market continues to demand some type of restructuring.

Social Impact

Higher prices of food and now energy helped spark social unrest around the world. In the case of the Middle East and North Africa, the social outcomes are feeding back into commodity prices themselves-specifically oil, causing further upward pressure. While the Fed obviously can't be directly blamed for instability in the Middle East, its loose monetary policy has added to the speculative fervor currently focused on commodities.

More threatening than the Middle East, at least economically, is the growing potential for protests in China. To be sure, China's political structure makes it less likely for a full-blown revolution to take place there, as analysts such as Ian Bremmer of Eurasia Group have argued. Still, any major disruption or slowdown to its current growth rates of 8 to 10 percent a year would probably lead to instability in that country.

A fair number of analysts have observed that China is in the midst of a massive real estate bubble, which would likely come crashing down given any major social disruption. Because of this possibility, it's probably best to avoid exchange-traded funds such as the Guggenheim China Real Estate ETF (NYSEArca: TAO ) for now.

The irony of spiking oil prices, as some analysts have already pointed out, is that ultimately this process is deflationary. One of the major reasons the Fed isn't worried about inflation is the fact that wage growth has been nonexistent. This is in part due to cost-cutting by corporations, including layoffs, that has fueled stronger-than-expected earnings over the last several quarters. The result is record profit margins that many feel will contract if commodities continue their ascent.

High commodity costs not only pressure companies' margins directly, but also indirectly, because they are like a tax on their customers. Should this feed through meaningfully to the bottom line in the coming quarters, Ben Bernanke's QE 2-induced wealth effect may become a mirage.

Also, more deflationary effects could come from social unrest should it continue to rear its head around the world. That's especially true if it spread to more economically vital countries, which would reduce aggregate demand.

At the end of the day, oil's recent volatility is an example of the cost associated with our current path of economic growth. The Fed's actions have stealthily been debasing the dollar and giving commodities prices a much higher "base" to launch from.

Keep in mind that none of this information is "news." Accommodative monetary policy, rising stock and commodity prices have been the themes for the last 24 months. With everyone on one side of the boat, I think the U.S. dollar as represented by the PowerShares DB U.S. Dollar Index Bullish Fund (NYSEArca: UUP) could be an interesting contrarian play.

Chadd Bennett is a trader and former financial advisor specializing in fixed income. He worked at Bear Stearns when it collapsed, then joined Morgan Stanley Smith Barney.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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