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Knowing the unknown

Political situations are difficult to predict but advisers must prepare client portfolios in case oil prices go even higher

Stockmarkets are never good at politics. Forecasts for the year ahead factor in a wide range of interest rate and growth scenarios but rarely tackle this big unknown.

The potential impact can be great but analysts find politics too hard to factor in. Without sensible forecasts, how can portfolios best reflect the risks?

Political uprisings in Tunisia, Egypt and Libya, which represent only a small proportion of the global economy, have had little effect on the stockmarket. However, oil prices have spiked at an alarming rate, allowing little time for consumers to react or even for companies to explain the impact on profits. Only later in the year, as results emerge, will we be able to see which businesses can pass on costs and which will see profit margins squeezed.

Analysts are generally not good at forecasting this flexibility in pricing – even strong businesses such as Tesco are struggling to raise prices. The oil price rise has been mirrored in the strength of other commodities such as cotton and food. The gold price has also been strong, reflecting its value as the potential currency of choice for deposed dictators.

But the real shock may be yet to come. Saudi Arabia does not require a regime change for markets to panic. Weakness in the Saudi stockmarket and its banking shares already point to real fear and could cause a further spike in oil prices. Although ultimately deflationary, the early impact will add to inflation worldwide and could trigger a round of profit downgrades and a stockmarket setback.

Industrial sectors, particularly capital goods manufacturers and engineers, could be hardest hit.

The global economy is recovering but confidence in capital investment is fragile and costs are hard to pass on.

The UK, a big energy importer, with plans for power generation lagging competitors, will be deeply concerned with high oil prices. The US may prove less exposed to an oil price rise and the oil price in the US has lagged to date.

Although markets have witnessed weakness in transport and industrial sectors, real assets, affording some protection against inflation, have held up better. Oil producers, miners of precious metals and property have all been performing recently. As expected with a pick-up in inflation, bonds and fixed-interest securities have been weaker. Investors should ensure they are comfortable with their portfolio balance and also look at liquidity in small and mid-cap shares, which could quickly fade.

The recent oil price rise has been much smaller than in the 1970s and in 1990. Each of those times, the global economy subsequently moved into recession but the current rise in oil prices has been less extreme and today’s oil intensity of economic activity is one-third lower than in the 1970s. There is greater efficiency and use of energy and low energy sectors, such as services, has grown. An oil price of $110 per barrel may not hugely dent world growth.

However, a spike higher could change everything. Even if analysts are not allowing for this risk, investors should prepare themselves and their portfolios.

Colin McLean is managing director of SVM Asset Management

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