Oil dynamics...

The record surge in oil prices has sparked debate as to what portion of the actual rise can be attributed to pure speculation and what is due to fundamental demand and supply imbalances. It is clear from the rapid rise that speculation has been playing a role but part of the reason behind the difficulty in determining exactly what role speculation has been playing is because of the increasing opacity in demand and supply information. This, in turn, is partly due to the emergence of new players in the oil business, particularly countries like China where transparency is not really part of tradition. There is also growing concern that oil supplies have been overestimated and that the current rise is reflecting an adjustment to reality which is that existing fields have peaked (or are in decline) and that new discoveries are both less frequent and smaller in size (making the business of discovering oil fields a more costly undertaking).
In summary the price hike is reflecting imbalances resulting from the challenges of finding new fields to cover not only a continual drop in output from existing supplies but also to satisfy increasing demand coming mainly from energy hungry emerging countries. To this we can add what has become a perpetual risk premium in the form of geopolitical factors such as limitations in discovery due to war (as in Iraq, Nigeria) or regime change (as in Venezuela).
Although it is very possible that speculation is playing a significant role in the current pricing of oil and that we will eventually observe a large correction, the days of abundant and cheap oil is clearly a thing of the past.

Between a U, a V and a W...

I think we can confidently rule out a V shaped recovery at this stage which leaves us with a U shape with its longer "slump" and a W shape, better known as the double dip. The difficulty in forecasting how the current environment will unfold stems from the lack of any historical precedent from which to make inferences (a bit like trying to guess the source behind the commodities spike). Taking a look at the most recent economic figures would have you believe that the economy is exhibiting a remarkable degree of resilience considering almost 10 months of turmoil. Sure, an economy jolted by an ongoing housing recession, a credit squeeze, shrinking real wages and skyrocketing commodity prices is showing signs of fatigue through deceleration, rising unemployment and a steady contraction of profit margins (first quarter earnings were on average 26% lower than the first quarter of last year), not to mention the recent collapse in consumer confidence. What is baffling, however, is when using the past for guidance, at this stage of a slowdown we should be observing an overhang in inventories and investments (we have only observed it in housing so far), businesses should be shedding a far greater number of workers, consumers should be consuming much less and the economy should actually be contracting rather than just decelerating. Instead we have what seems to be a mild response to a major crisis, or a sneeze through which you catch a cold but not the flu! Maybe in the new world we live in the shock absorbers are much thicker which makes the lags much longer and therefore it is just a question of time. It could also very well be that the crisis was well handled by the Fed and, combined with the timing of the injection of government tax rebates, the forward looking markets are already riding a recovery wave in contrast to the lagged economic releases that are still stuck in the slowdown phase. That would in fact make the shape of the recovery more like a tight U (closer to a V). But what if markets are overly optimistic and we are in fact in a doldrums stage just before the second wave of a credit crisis (credit card and car loans anyone?) hits the markets? That would make it a perfect W double dip. To be honest, with so little past data to lean on for guidance, it is exceedingly difficult to predict how the current crisis will unravel.

A reversal of roles?

There has been much debate lately as to the degree of correlation between developed and emerging markets. Looking back, a sharp downturn in developed market economies would almost certainly drag the rest of the world with it. This was mainly due to the dependency of export oriented emerging markets to the vagaries of developed market consumers. In the era of globalization the dynamics have changed somewhat as a number of emerging markets have adopted the capitalistic consumer oriented market economy by embarking on a radical course in reform leading to rapid industrialization and the emergence of a distinct middle class. The emergence of the domestic consumer has had a somewhat cushioning effect (at least so far) on the impact of external demand shocks as seen by the remarkable resilience of the emerging markets to the housing and credit led turmoil. Does this mean that the relationship has moved from traditionally high correlation to one of low correlation? Not necessarily if we consider that the strength of third world economies may be what is keeping the crisis laden developed markets afloat. If that is confirmed, it would indeed be a historical first, a sort of reversal of roles.
This new role for emerging markets doesn't come without perils, however, as we observe a general surge in inflation in many of the commodity oriented economies of developing countries. Ever since the Federal Reserve began slashing interest rates, those countries that have currencies that are closely linked to the dollar have had to follow suit. With economies that are already running at capacity, rate cuts have had the effect of pushing up prices as supply struggles with surging demand. There has been some attempt to revalue the currency such as in China, but this has not been sufficient to cap inflation. As the Fed takes a pause from its accommodative stance, the dollar is showing signs of bottoming and if the crisis does abate, it will have a much needed alleviating effect on red hot emerging market economies.

Does trouble come in clusters?

History is scattered with anecdotal evidence of clustering and a casual observation of the markets would seem to validate this proposition, particularly with regards to the more recent past. Take a look at skyrocketing oil prices with what seems to be no end in sight. The initial surge, triggered by a combination of a rapid acceleration in third world industrial development, a steadily weakening dollar, market turmoil related speculation and greater difficulty in finding new reserves is now being further fuelled by a confluence of random supply shocks (most recently with the militant attacks in Nigeria).
Food is showing a similar pattern in which an initial surge in prices, triggered by a steady rise in demand (again from the wealth effect of rapid development in emerging nations) combined with supply strains (resulting from ill conceived government incentives) is being further exacerbated by random events such as the devastating cyclone which hit Burma as a time when the price of rice is at record levels.
Mind you, we don't really need to confine ourselves to the universe of commodities to observe the phenomenon of clustering. Take the example of UBS, the largest wealth manager in the world, already reeling from record losses related to subprime, is now facing allegations by the U.S. department of justice for having advised clients on tax evasion.
So it would seem that trouble tends to feed on itself which means that those of us in the money management business should be paying more attention to the fat tails. Doing so may lead to improved risk management.

From Wall Street to Main Street...

The current economic crisis which began with the sharp rise in subprime delinquencies earlier last year seems to have remained within the confines of Wall Street. The latest data suggest that main street was and remains relatively unscathed by the turmoil. Corporate earnings for the first quarter has been a mixed bag of surprisingly good and very disappointing results, inflation seems to be relatively tamed, unemployment is not exploding and preliminary first quarter GDP would have you believe that the economy did not contract yet.
Vital signs for the markets are also turning back to normal as observed with the sharp decline in volatility, a sharp rise in treasury yields, the stock market rally and what seems to be a recovering dollar. Even the Fed has alluded to a pause after the most recent 25bp cut in order to assess the impact of its actions.
With all the positivity out there one may wonder if the economic turmoil has reached bottom. I for one remain skeptical that the rebound can be maintained because fundamental issues such as housing deflation, strained lending and record commodity prices continue to plague the markets. The housing deflation and credit markets pose a significant threat to the well being of main street and therefore need to be addressed rapidly and effectively. Cutting the target rate is not going to stop home prices from dropping but we cannot deny that the additional actions taken by the Fed have had a soothing effect on credit markets although the TED spread (3Month Libor - 3 Month Treasury) at 1.37 is still considerably above the 0.20 to 0.35 levels of the period preceding the crisis. As for commodities, the persistently higher prices suggest that the underlying mechanism has changed meaning that we can no longer rely on a simple economic downturn to bring prices back to more normal levels.
Bottom line is that many outstanding issues continue to pose a threat to the recovery (if that is indeed what it is) before we can give the economy the all clear.