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John Manley

What would Chair Yellen do if Iraqi crude stopped flowing?

AdvantageVoice® Blog—6-23-14
John Manley, CFA, Chief Equity Strategist

It all seems so eerily familiar. The script appears to be playing out for the fourth time in my lifetime: A localized conflict in the Middle East seems to emerge from nowhere; oil supplies are threatened, then interdicted; and oil prices more than double—the resultant oil shock sends the U.S. economy into a recession and, then, the U.S. stock market into a bear market.

The first three oil shocks remain clear in my mind. The first began with the Yom Kippur War of 1973. Egypt and Syria invade Israel on a high holy day. The Israelis stumble, then recover and push the invaders back. The U.S. agrees to resupply Israel, and the Arab members of OPEC, in retaliation, cut off their crude exports to us. Oil prices rise from around $2 a barrel to around $15. The U.S. Federal Reserve (Fed) sharply raises interest rates to curtail inflation. The economy falls into a deep recession, and before it is over, the American stock market has declined close to 50%.

The second oil shock begins in 1978 with the overthrow of Iranian Shah Reza Pahlavi and continues through the outbreak of war between Iran and Iraq in early 1980. Oil prices move from around $15 per barrel to $35. The Fed initiates a series of draconian rate hikes to stop inflation once and for all. Before it is over, U.S. stocks are down more than 25% from their highs.

The third shock begins in August 1990, as Iraq invades Kuwait. The U.S. plans and then executes a reconquest. Oil prices spike to twice their prewar level. The Fed is not as certain about inflation as it was in the two prior spikes. It pauses an already ongoing gradual rate-reduction process and lets the higher prices slow the economy. Once the impact on the economy is felt, the Fed slowly resumes its rate-cutting. U.S. stocks are down around 20% before they stabilize and recover.

These are not pleasant recollections to entertain in an environment that has seen equity prices more than double over a five-year period of limited corrections. To those who say that we are overdue for a painful downturn in equities, ISIS seems perfectly cast to be the catalyst. Now, as in the past, America can do little to stop events that would push oil prices higher, and once oil prices move up, the story goes, events should follow the pattern that they have followed three times before in the past half century.

I am not sure that I believe that.

I do agree that the events in the Middle East were uncontrollable and that, once they occurred, the rise in oil prices was unavoidable. However, I don’t know if the Fed will do today what it did in the past. That is the one thing that Americans control, and I think we may not see a repeat of past Fed actions and past significant equity market declines.

The world is different than it was in 1973, 1978, and 1990. Specifically, inflation is no longer the dominant economic concern in the world—deflation is. In the previous oil shocks, the Fed rightly believed that higher crude prices would easily be passed along to consumers and businesses. The Fed had to raise rates to stop this from happening.

Today, given the lack of pricing power seen in our tepid five-year recovery, I do not think that it is at all certain that Chair Yellen would feel the need to tighten. If anything, the headwinds of lower crude supplies and higher prices might bring more stimulus if those higher commodity prices produced lower demand instead of higher prices.

We will see what happens. I suspect that the bear markets of 1973–1974, 1980–1982, and 1990–1991 were brought about by a tight Fed, not directly by higher oil prices. If oil prices jump (and that is far from certain) and the Fed pushes liquidity at us to counteract this, I think significantly lower stock prices is even less certain.

The views expressed are as of 6-23-14 and are those of Chief Equity Strategist John Manley, CFA, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

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