So investors, what if the oil price heads south again?

Strong oil and weak dollar influence shares, EM, junk debt and FX
Refinery operated by MOL in Szazhalombatta, Hungary © Bloomberg

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We are all oil traders at the moment.

The resilience of crude prices in the wake of a failed production freeze deal in Doha firmly illustrates the importance of black gold for sentiment across the broader financial system at the moment.

Talk of a freeze in recent weeks propelled the robust recovery in oil prices. However, the lack of an agreement and the crackling tension between Iran and Saudi Arabia is being downplayed by energy traders. They are looking ahead to the prospect of supply and demand becoming balanced during the second half of the year, thus supporting crude prices.

Relief that oil prices quickly reversed their opening plunge on Monday after Doha helped drive global equities to new highs for 2016 this week, as measured by the FTSE All World index, extending a broad recovery from the February lows. A relief trade is certainly driving US shares at the moment as investors cheer companies beating heavily reduced earnings expectations, notably US banks.

The yin and yang of a firmer oil price and a weaker dollar have exerted considerable influence over the performance of equities, emerging markets, junk debt and dollar-bloc currencies in recent months.

A lower US dollar, shackled by a Federal Reserve reluctant to push up borrowing costs in the face of a fragile global economy, has also bolstered commodity prices and calmed emerging markets, notably China, where the prospect of a currency devaluation sits on the back burner.

Importantly, the rebounding oil price has calmed the fears of a deflationary spiral that rattled markets at the start of the year and had some questioning the effectiveness of central bank policy.

Investors are interpreting higher commodity prices — led by Brent crude approaching $46 a barrel on Thursday, the highest level since late November — along with very supportive central bank policies as signalling stronger economic growth later this year.

Here the upbeat mood of the oil market chimes perfectly with the eternal optimism of many other investors; it’s all about the second half of the year. Forget the troubling signs that asset prices have rebounded sharply on the back of no real improvement in underlying fundamentals. There appears plenty of faith in the idea that bad debts related to the energy sector are contained and that the present S&P 500 earnings recession will fade, justifying rising valuations by the end of the year.

At a time when investors flocked for a slice of Argentina’s $16.5bn sale of government debt, plenty of money is clearly sloshing through the financial system, looking for a home and downplaying risk in favour of return.

Analysts at JPMorgan earlier this week made the interesting observation: “Investors have re-levered and adjusted their positioning, with macro funds, long/short equity strategies, volatility targeting and risk parity portfolios having already increased their exposure to equities.”

Other analysts are also warning that positioning in general is becoming far too bullish, raising the prospect that markets are getting ahead of fundamentals. Given how many highly paid active investment managers missed the rebound in equities back in February, the suspicion is that they are now making up for that missed opportunity.

The robust performance of small capitalised stocks suggests investors are playing a game of catch-up, buying shares with a higher beta, or those whose price rises faster than that of the broad market, rather than betting on a stronger domestic US economy.

So what can possibly go wrong?

Crowded positioning across many markets is vulnerable to any type of shock that upsets the current narrative. That brings us back to the oil price, where bets on higher crude are at, or near, record levels.

As already seen earlier this year, a pronounced slide in oil back towards $30 a barrel or lower has the power to inflict considerable damage across the financial system and reinvigorate market volatility.

The disinflationary consequences of cheap oil present a considerable challenge to central banks and expose the limits of interest rate policy, a point firmly made during the International Monetary Fund’s annual meeting in Washington last week.

Plenty is riding on a resilient oil price.

michael.mackenzie@ft.com

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