Soaring Oil Prices: A Mounting Threat To The Global Economy

The risks of an oil supply shock are rising as Middle East tensions escalate.

Crude oil prices spiked further yesterday as worries that a full scale war between Israel and Lebanese factions could develop. The list of potential supply disruptions was already long and this latest crisis is adding to market tensions. The global economy has been coping with high and rising oil prices for five years, but a choke point may be at hand because the most recent price gains are not being fuelled by strengthening demand. Consequently, oil prices are exacerbating the budding global economic slowdown. Bottom line: While it is not clear how the geopolitical situation in the Middle East will play out, any further upward pressure on oil prices will undermine global growth prospects and equity markets, while boosting government bond prices.

Higher energy prices remain a significant threat to the UK economy. This is despite the fact that growth and inflation have appeared to be largely unscathed from recent rises in oil and wholesale gas prices to record highs. What's more, in contrast to conventional thinking, the true danger may no longer come from the oil price, but from the wholesale gas price.

U.K. Consumers: As Goes Housing...

A rebound in the housing sector is providing support to retail sales, but this should not compel the BoE to hike in August.

The BRC survey of retail activity rose in June, and is now at a four year high. The uptrend is consistent with the improvement in house prices and the increase in mortgage equity withdrawal, which in the first quarter was nearly double YoY level. The uptrend in retail sales also corroborates the BoE expectations outlined in the June MPC statement. To a large extent, policy will be guided by external events the slowdown unfolding in the U.S. represents a key risk, especially since the €uro area has not yet developed strong domestic demand. Bottom line: It is a close call, but the BoE will probably stand pat at its August meeting.

The Global Growth Slowdown Is Underway

Global economic momentum is beginning to cool, led by the U.S.

BCA's Global Leading Economic Indicator (GLEI) edged lower in May, dipping below the boom/bust line and continuing the downtrend that has been underway since January. The weakness is concentrated in the U.S., where an erosion in housing is beginning to feed through into the overall economy. However, BCA's global ex-U.S. measure is also drifting lower, suggesting the recent string of strong data will soon give way. It also underscores that the rest of the world will struggle to sustain momentum as the U.S. slows, especially given tightening monetary policy and high energy prices. The silver lining as global growth decelerates is that inflationary pressures should abate and calm fears of excessive monetary tightening. The downside is that growth sensitive assets such as commodity prices and emerging market and small cap stocks may remain under pressure.

As Goes The U.S., So Goes The World

A U.S. economic slowdown will reverberate strongly across the rest of the world.

Many investors are hopeful that the global economy can comfortably withstand the unfolding U.S. economic slowdown. History suggests otherwise. U.S. import demand correlates very closely with the U.S. economic cycle, indicating a significant further weakening of U.S. import demand lies ahead, even assuming the U.S. experiences a soft landing. There is also a strong correlation between U.S. import demand and world exports; the implication is that weaker U.S. import demand will exert a clear restraint on global export activity. Bottom line: Slower U.S. economic growth heralds a moderation in global growth, the signs of which are just beginning to emerge.

Technically speaking

FTSE-100 (5765) dropped a hefty 95.6 points yesterday as investors responded to lower prices on Wall Street, escalating violence in the Middle East which, in turn, was causing the price of a barrel of oil to start climbing again. The index was heading for a fall to around 5790 and the fact that this Fibonacci retracement level was exceeded greatly increases the chances of a pull-back to the next level i.e. at around 5730. However, the way that the index gapped lower yesterday implies that the selling pressures could be sufficient to take it back to a 50% retracement of the rally from last month's lows, and that would mean a drop to 5680 or so. In short, the volatility has not gone away.

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.