What Do High Energy Prices Mean For Equities?

A new week has dawned with markets looking a touch rickety. This has frankly come as a bit of a surprise to Macro Man after Friday’s by-now de rigeur late-session squeeze in the S&P 500 (^GSPC), as well as broadly supportive policymaker comments over the weekend. The G8 is not quite ready to take away the punchbowl, it seems, and the BRICS have (in public at least) pulled back from seeming to want to create a dollar crisis. And for today at least, the ususal suspects have been absent from the FX market.

Perhaps the most amusing comment from the weekend came from German FinMin peer Steinbrueck, who warned of further credit dislocations in Europe, putting his marker down to cover his ass in case it all goes wrong. Evidently, winning “European Plonker of The Year 2008″ for his powerful mix of forecasting ineptitude and hubristic scahdenfreude deeply affected him, as it seems he wants to avoid a repeat victory.

Regardless, markets are trading on the back foot to start expiration week. There are a number of indices that seem to have stopped in their tracks over the past month or so, remaining broadly supported but unable to breach recent topside highs. Momentum has clearly ebbed and, technically at least, the set-up for shorts looks reasonably attractive. The SPX and Eurostoxx are currently supported by their 200 day movering averages in close proximity, but something like the FTSE Midcap 250 has a lot of room to fall before entering the neighbourhood of the 200d MA.

One issue that has been gnawing at Macro Man has been the seemingly bullet-proof performance of equities over the past three months despite a very real hit to global disposable incomes and operating margins thanks to the sharp rise in energy prices.

Now to a degree, the positive correlation between energy and equities can be seen as a function of either reflation or short-covering. Macro Man hasn’t got much of a beef with that interpretation.

However, the strength of the relationship has really puzzled him, as it’s felt like oil and equities have been the same trade since March. Even if it is the energy sector that has led the rally (and really, it’s been the financial sector), the same thign held true last year.

And yet the correlation between daily equity returns and returns on crude oil (as proxied by the second WTI future) has never been higher, at least since Bloomberg’s crude futures data starts in 1986.

Now, Macro Man would be willing to bet that this high level of correlation is not sustainable. The hit to disposable incomes from high and rising energy prices is like an industrial-strength dose of Roundup poured on the global economy’s green shoots.

How to play this relationship directly is another matter. His discreet enquiries about exotica like SPX/CLZ9 correlation swaps met with zero interest from his panel of counterparty banks. Frankly, it would probably meet with zero interest from his risk manager as well.

Playing the markets individually in a linked strategy introduces an element of conditional directionality that undermines the ‘purity’ of the trade. So for the time being, Macro Man is watching…and waiting. At some point, the penny from high energy prices may well drop into the equity market space. Macro Man intends to be there to pick it up.

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