Modest recovery in oil prices will benefit equities

Last week, the Organization of the Petroleum Exporting Countries (Opec) agreed to cut the crude oil output by 32.5 to 33.0 million barrels a day, the first such move in eight years.

Subsequently, the oil (Brent) price has rallied above $50 a barrel. Over 55% crash in oil price since its peak in June 2014 enabled India to save a lot of forex reserves, minimised the current account deficit and also helped the equity markets remain robust. After this Opec decision, the concern is whether oil price would zoom further and spoil the outlook of the domestic stock markets.

First of all, any solid bull run in the oil price is most unlikely as many economies in the world are still going through deflationary fears. In fact, the World Bank has decreased global growth forecast from 2.9% to 2.4% recently.

Further, the World Trade Organization has cut its forecast for global trade growth this year by more than a third to 1.7% last week, down from its previous estimate of 2.8% in April. This is the first time in 15 years that international trade is expected to lag the growth of the world economy. Hence, only modest recovery in the oil price can be expected at this juncture.

Secondly, the association between oil price and the equity markets is misunderstood by many. Cheap oil is good for the equity markets but at the same time oil becoming too cheap is bad for the markets. Similarly, significant rise in oil prices indicate robust outlook for the global economies in terms of aggregate demand shifting vertically. However, booming oil price over $100 a barrel would lead to an inflationary trend, which in turn would result in monetary tightening. The same would cause the equities to fall.

The classic example was in 2007-2008 when the oil price moved up 63% from around $57 a barrel in January 2007 to $94 a barrel in December 2007. The Sensex moved up 44% in the same period. However, when oil price zoomed further by 49% to around $140 per barrel in June 2008, the Sensex crashed by 34% during the period December 2007 to June 2008.

The Sensex hit a life-time high of over 30,000 in March 2015 when oil price ruled around $55 a barrel. However, when oil price crashed by roughly 50% by January 2016 to around $27 a barrel to touch a 12-year low, the Sensex fell by 17% within a span of 10 months to around 25000-levels. Across the world, the equity markets fell in January 2016 as the crash in oil price was a result of rising global deflationary pressures. Hence, any modest recovery in oil price even up to $60-65 a barrel would alleviate the fear of global deflation and would help the equity markets. The same would lead to rise in income levels of oil producing regions and also help the economies like Japan, Euro zone and even the US to achieve the inflation targets. Consequently, the robust outlook for the global trade and economic growth would help the equity markets especially the Indian equities to rise further provided the tension on the Indo-Pakistan border moderates.