Crude's positive co-relation with equities

If markets are in a ?risk on? mode, equities tend to join the crude rally

High crude prices are not good for India’s economy because of the havoc they wreak on inflation rates and fiscal deficit. But equity strategists believe there’s a positive correlation between crude prices and stock markets, though only up to a point. In the past 10 years, 89 per cent of this correlation has been positive, and 67 per cent in the last three years. So, is it surprising that though Brent crude prices have moved up 14 per cent since February 1, the Sensex has not fallen? In fact, the benchmark index is up three per cent.

Jyotivardhan Jaipuria, head of research at Bank of America Merrill Lynch (BofAML), believes the rally in oil prices, as well as the Indian market, is probably linked to a “risk-on” trade globally, which both represent. “However, if the risk on trade continues to play out, we may see this correlation turn negative. Our guess is, we are close to this tipping point.” If crude rallies by over 30 per cent in less than three months, the correlation turns negative and markets give negative returns.

However, the positive is that over time, India’s ability to withstand crude shocks has only improved. In a macro sense, oil at $110/bbl today is like oil at $70/bbl in 2007. As explained by Jaipuria, net oil imports remain around four per cent of gross domestic product (GDP) and the oil subsidy at around 0.8 per cent of GDP, similar to 2007, although oil prices are over 50 per cent higher.

So, what is the inflexion point from where crude and equities move in opposite directions? According to Citi’s estimates, $110 is the approximate point of indifference/cut-off level. However, “this is likely a moving level – our back-tests of the previous two crude cycles suggest the level was closer to $90 then. This time, India has underperformed from $110+ levels, and it could well be an inflexion point for relative performance”. Equity strategists say though the correlation works in the early part of the crude oil rally, the fair value of the markets should determine the long-term strategy.