David Morris
LAST week provided a reminder that equities can go down as well as up. Although the sell-off was small in percentage terms, it has been a long time since the major global stock indices experienced a number of successive losing days. The pull-back was triggered by strength in the oil price. Brent crude finished up 10 per cent on the week and briefly traded above $119 on Thursday as the situation in Libya continued to deteriorate.

But the price of crude was rising long before civil unrest took hold across north Africa and the Middle East. After trading in a $20 range for 18 months, oil began to trend higher at the end of August last year and broke out above its trading range about three months ago.

The start of this move coincided with US Federal Reserve Chairman Ben Bernanke’s Jackson Hole speech, when he made it clear that the US central bank was ready to launch a further programme of asset purchases. It seems reasonable to conclude that fears of a pick-up in inflation, together with speculation fuelled by the Fed’s near-daily $8bn debt monetisation scheme helped to drive prices higher. Now, a potential supply shock thanks to civil unrest is doing the rest.

Investors will remember what happened back in mid-2008, when oil came close to hitting $150 per barrel. Six months later it was back around $40, but the initial rise contributed to the rout in equities which were getting hammered as the financial crisis took hold.

Countries around the world are already struggling to deal with rising commodity prices. At the same time, we are seeing interest rate hikes in Asian Pacific countries, austerity measures across Europe and a soaring budget deficit together with high unemployment and a dismal housing market in the US. Consumers are already getting squeezed, which means that companies will struggle to pass on the full effects of their rising input costs.

As a result, corporate profit margins are coming under pressure and we have already seen evidence of this in fourth quarter earnings from the US. Analysts are forecasting S&P 500 earnings per share to hit $97 in 2011, which will be an increase of just under 15 per cent from 2010. So there’s a fair chance that earnings will disappoint over the next six months, with or without another round of Fed stimulus.