Recently, oil prices reached another all-time high. The combination of a tight market and continuing fears about supply disruption - especially from Iraq where the security situation appears to have worsened during the week - helped to push the nearest dated crude oil contract on NYMEX to a high of $49.39 on the morning of Friday 20th August in New York. Oil prices have fallen from the new record to around $42 this week but rebounded to near $44 on 1st September.

The oil futures market is currently only pricing in a moderate price decline to around $40.00 by end-2005. We think that (barring any actual disruption to supply, rather than mere disruption speculation) this will prove unjustified, as a combination of OPEC output expansion and slowing demand growth serve to rebalance the supply and demand extremes of recent months. In the speculative near-term, however, the momentum behind a push to $50.00 p/b may prove difficult to resist. Ever higher oil prices, regardless of their fundamental justification however, will have both a depressing effect on global non-oil demand and serve to redistribute the relative strength of that demand between economies. As a reminder, the ZEW survey in Germany this week singled out high energy prices as one of the main factors depressing overall confidence in the German economy.

The Eurozone is required to import 100% of its oil consumption - as does Japan, the UK is more or less in oil-balance and the US imports around 60% of its consumption. The potential negative income effect to the Eurozone is therefore larger than the US - this impact has so far been mitigated to some extent, however, through the movements of nominal exchange rates. Since the beginning of 2003 the dollar price of oil has increased 48%, but only 25% in euros - what looks like a $10.00 p/b shock in the US is therefore only the equivalent of a '$5.00 shock' in the Eurozone. We expect the euro to strengthen against the dollar during 2005, so continuing to cushion the blow to Eurozone companies and households.

Chart 1: Oil price in local currency, 2003- 04

Our central case growth and inflation forecasts assume a retracement of the oil price to levels averaging around $30.00 p/b during 2005. If the current crude futures strip were to prove more accurate (although oil futures markets do have a notoriously bad record in this regard) then this would be sufficient to knock 0.5% from US growth during 2005 and 2006 and add 0.5% to headline CPI in 2005 and 0.6% in 2006. Without any further mitigating move in nominal exchange rates the impact on the Eurozone would be of a similar magnitude.

Despite the continued rally in oil prices, equities also managed a rally on the balance of the week - a sign that perhaps that investors are reaching the point where they feel much of the bad news on oil prices has been included in valuations. Oil prices that were to stay above $50.00 for an extended period of time, however, could result in a reconsideration of this assessment.

Oil And Monetary Policy

An additional uncertainty caused by a higher oil prices is how central banks around the world will react to the higher energy costs being faced by companies and households. Will the inflation effect, or the demand contraction effect dominate, and so will policy be more or less accommodative respectively?

The 'Monetary Policy 101' response for a central bank faced a negative supply side shock (such as higher oil prices) is to monetarily accommodate the increase in the price level if the economy is operating below capacity and to lean against the price shock if the economy is operating above capacity.

Chart 2: OECD output gap estimates

Recent OECD estimates of the output gaps in the US and UK suggest that there is neither a significant negative or positive output gap, and comments from both central banks also indicate institutional uncertainty regarding the size, and indeed the sign, of the output gap. The conclusion of the text book reaction function is therefore also unclear.

In practice we believe that, considering the 'emergency' rate levels the Fed is moving away from, movements in the oil price will not materially alter their intention to increase rates at a 'measured' pace, at least until a more 'normal' level of rates is achieved. Nonetheless, as we wrote last week, we would expect a lower interest rate profile should prices remain above $40.00 p/b, with Fed funds perhaps only reaching 3% by end-2005, rather than our current forecast of 4%. The rhetoric from the Bank of England suggests that they do expect a positive output gap by 2005 (resulting in their increasing inflation profile over that period) - so the MPC would presumably be inclined to stamp on the inflationary impact of higher energy prices more than worry about the growth impact.

In contrast, there continues to be a negative output gap in the Eurozone and so our basic central bank model would suggest that the ECB should ease policy in response. The verbal response of ECB officials to the increase in oil price to date, however, suggests that the Bank is worried about higher inflation expectations becoming embedded in the Eurozone and so would be inclined to do the opposite and tighten policy in response.

Peak In Corporate Earnings Poses Problems For Equities

The revival in US corporate sector profitability has been one of the key positives of the past three years. Reported earnings per share (eps) on the S&P500 have doubled over the past two years and are now higher than in 2000, the peak in the last cycle. This has allowed US equities to rise in value and de-rate at the same time, an achievement the bears like to gloss over. From a top-down perspective this gain was underpinned by strong productivity growth and a rise in the profit share in national income. At the corporate level it is seen as the product of retrenchment after the excesses of the bubble years and a new mood of conservatism now enshrined in Sarbanes-Oxley legislation and tighter corporate governance.

However, as we have highlighted in recent months, this is coming to an end: with the profit share at a new peak, the scope for further outsize gains in corporate profitability is limited. Profits growth is likely to slow into line with nominal income and then further as productivity growth slows and margins come under pressure. Our profits forecast is for a gain of more than 20% this year, but we see growth of about 2.5% in 2005. Of course, we may be wrong such that productivity growth proves to be stronger than expected and the profit share rises to new highs. This seems unlikely, although one interpretation of the recent pay-roll numbers is that companies are still in a position where they can raise output without increasing labour. Poor payrolls could be seen as good news for profits, but do not try telling that to the equity markets.

This week we examine what a peak in profits growth has meant for the performance of equity markets. We focus on the US and go back to 1950 as it is important to capture the period prior to the great disinflation of the 1980s and 1990s. During this period there have been 14 peaks in eps growth which were then followed by a deceleration of at least ten percentage points (see chart 3).

Chart 3: US EPS growth (reported S&P measure)

The subsequent performance of the market was mixed ranging from a gain in the S&P of 36% in the twelve months after the eps peak in March 1997 to a fall of 29% in 1974. Out of the 14 episodes, eight were followed by a rise in the equity market in real terms whilst six experienced a real decline. The average change in the equity market was a rise of 6.5% (1.5% after inflation), but given the range of experience this is not particularly meaningful.

Looking more closely though a pattern emerges in that all the loss making periods, with the exception of the experience after March 2000, occurred between 1959 and 1976. After 1979, periods of slowing eps were accompanied by gains in equity markets, often substantial. This winning streak came to an end in 2000 as the downturn in eps heralded the start of the bear market.

The key difference between the two phases was the behaviour of inflation and bond yields. during the positive return periods In the year after earnings peaked, inflation and bond yields declined by around ½% and 1% respectively (see table 1). This enabled the equity market to re-rate such that a rising PE offset the slowdown in eps. In contrast, bond yields and inflation rose during the negative return periods causing the market to de-rate.

Coming back to the present day, this suggests that over the next year as eps growth slows, we will have to see a re-rating for equities to make progress. On past experience this has been driven by lower inflation and bond yields. However, starting from today's levels, just under 2% for core CPI, it is not clear that this would be seen as positive for the equity market. Should inflation fall from here we would be back toward the levels which triggered fears about deflation and concerns that the US was about to emulate Japan. Bond yields would certainly fall, but it would not necessarily lead to a re-rating of equities as deflation worries would raise doubts about corporate earnings. With interest rates at 1.5% there would be concerns about whether the Federal Reserve could do enough to stimulate activity.

Before becoming totally bearish, two points need to be made:

First we are not forecasting outright falls in earnings. We still expect quarterly gains and a slowdown in growth not an outright recession, although the dangers of the latter have been increased by the rise in the oil price. Our current projections have the PE falling to 17½ at the end of this year and just below 17 at the end of 2005. So the market can de-rate while remaining at current levels as earnings continue to rise. However, even at 17 times, the PE is high and almost identical to the average starting point in the period of negative returns.

Second, some of this may already be priced in. The relationship between equity and bond yields has shifted against the former i.e. bond yields have declined and dividend yields have risen. This is reflected in our risk premium calculations which include expectations for growth and inflation to estimate the expected return of equities over bonds. At present this measure is well above average since 1990, an indication that equity markets are already pricing in a significant amount of risk.

Chart 4: US equity risk premium (excess return of equities over government bonds)

Overall, we would conclude that the turn in eps is a signal to reduce equity weightings on a one year view. In mitigation some of the bad news appears to be priced in, but we would have to see a better earnings outlook for US equities to make much progress.