The stock market continued its advance in the first quarter of 2012. The US benchmark S&P Five-hundred stock index rose 11.9% to 1408 as a persistent and broad cross section of economic data pointed to a strengthening economic recovery. Also influenced by the outlook for a stronger economy, the yield on the benchmark ten-year US Treasury note rose 35 basis point to 2.22% from 1.87%. The price of gold rose 6.7% to $1,672 per ounce, while the price of the US benchmark West Texas Intermediate (WTI) crude oil rallied 4.2% to $103.02 per barrel on a tight market and fears over military conflict with Iran. The international benchmark Brent crude oil futures contract increased more substantially, 14%, to $122.88.
While leading stock indexes have advanced strongly, and many have called an all clear on the outlook for economic recovery, a plethora of potential difficulties remain. In Europe, while official actions (such as providing long-term financing for banks and arranging a second Greek bailout) have avoided an immediate catastrophe, European economies remain weak, and their financial system fragile. Emerging markets, particularly China, are also experiencing a bout of economic weakness. While America is a net importer of foreign goods, it is still exposed to the global economic environment through exports, which remain a significant sector of the economy. Furthermore, many important American firms have significant foreign operations, the performance of which can heavily impact share prices.
American politics remain highly partisan and dysfunctional, but with the full year extension of the Administration’s payroll tax cut, a potential bullet was avoided. While the next major legislative hurdle on the horizon is passing a budget or a continuing resolution by the end of September, we find it highly unlikely that either side has the appetite for a budget crisis immediately before a Presidential election. Following the election, a veritable avalanche of major issues will hit, such as the expiration of the Bush and payroll tax cuts, the automatic budget sequester, and an increase in the debt ceiling. We believe these significant issues will take a back seat to the Presidential campaign and election, and are therefore unlikely to appreciably impact markets in the meantime.
The price of US benchmark WTI crude oil increased in the first quarter of 2012, 4.2%, with gasoline prices rising more dramatically. (The price of gasoline is also affected by the supply of oil refining capacity and the availability and source of oil, i.e. West Texas Intermediate versus more expensive Brent.) If prices were to advance further, they could have the potential to threaten the US economy’s recovery and concomitant stock bull market. The elevated prices have three main components. As the global economy continues to recover from the financial crisis, demand for oil and gasoline has increased. At the same time, geopolitical issues such as those in Syria, Yemen, the Sudan, and most of all Iran, have led to a decrease in the supply of oil. As an added complication, the threat of an Israeli air strike on Iran and a wider war in the Persian Gulf has introduced a further risk premium to the price of oil.
The Saudi Arabians, who are well aware of how a spike in oil prices helped spark the financial crisis in the summer of 2008 (that ultimately decimated demand for their oil), have vowed to increase supplies to insure that oil prices do not appreciate further. They have said they are willing to increase their output by up to 25%, and claimed to have made the infrastructure improvements over the past four years necessary to do so. We are agnostic about how this battle of supply and demand plays out, but we are monitoring it closely.
The wild card in all this remains a potential Israeli strike on Iran. An Israeli attack could result in significantly higher oil prices. On this we remain confident that the Israelis will not strike while economic sanctions and diplomacy have not yet run their course. As we have said before, an attack on Iran would push the limit of Israel’s capabilities, and is too high risk of an operation for them to undertake at this time. Ultimately, if Israel concludes that there is no hope for sanctions and diplomacy insuring that Iran does not develop a nuclear weapon, a strike, by Israel and/or America, would be likely. The bottom line, however, is that we believe the possibility of an actual attack is a 2013, or later, issue. That having been said, the mere threat of an attack in the minds of market participants will continue to have a heavy influence on the price of oil.
Given the myriad of potential difficulties facing the stock market, we have a cautious outlook for the remainder of 2012. We are not outright negative because we do believe the growth momentum presented in the economic data is real. Employment is improving, which leads to increased spending, which leads to improved employment, and so forth. Corporations remain financially strong. The stock market may be able to navigate the difficult road ahead, but as always, we strive to remain fully aware of all potential hazards. For the remainder of the year we see the S&P 500 trading in a range of 1275 to 1500. It closed the quarter at 1408.