LONDON (Reuters) - Investors face a key stress test in the coming week as the Middle Eastern political crisis, rising oil prices and expectations for higher interest rates slow the ascent of world stocks near their 30-month highs.
A rally in world stocks, measured by MSCI .MIWD00000PUS, stalled just near their peak of mid-February as oil prices raced to 2-1/2 year highs in the face of escalating violence in Libya and other Arab countries.
However, in a sign of resilience, the MSCI index bounced 1.4 percent in the past week as investors focused on improving corporate and economic fundamentals, with world growth still expected at a reasonable rate of 4 percent this year.
Data from Thomson Reuters Lipper showed investors put $2.3 billion of fresh cash into U.S. equity funds in the week ended March 2, although they did pull out money from emerging markets.
Oil will hold key for investors in the coming week, which will see Saudi Arabia’s planned protest and a key summit of European leaders on Libya and the sovereign debt crisis.
According to Reuters data, 30-day rolling correlations of the MSCI world stock index and U.S. crude oil hit -0.4 percent, levels last seen in early 2008. This means stocks fall when oil rises and the link is strongest in three years.
“Markets have been spooked by fear that we may be in for a 1970s style oil shock. Oil price worries are keeping markets from rallying further,” said Lothar Mentel, chief investment officer at Octopus Investments.
“There isn’t too much new bad news from trouble spots, and good macroeconomic news can dominate the market but that can change very quickly. I wouldn’t put my money in the sustained rally next week.”
Oil prices and the Volatility Index .VIX — Wall Street’s so-called fear gauge — have also started to move in tandem in the past few weeks.
Saudi Arabia’s stock markets .TASI, largely dominated by domestic investors, plunged to fresh 22-month lows on Wednesday before its weekend as concerns intensified ahead of planned protests in the top oil exporter on March 11 and 20.
Dubai .DFMGIand Kuwait .KWSE shares hit 6-year lows on Thursday.
Investor resilience stems from their confidence that the world economy, backed by cheap and abundant cash, will stage a strong recovery this year.
Reuters calculations show world GDP growth will halve to 2.1 percent in 2011 from current projections only if Brent crude oil reached $150 a barrel, a 30 percent increase from Friday’s prices.
Oil will have to reach as high as $191 to wipe out world growth, based on assumption that a $10 percent rise in oil prices trims global growth by around 0.5 percent.
And the corporate sector remains healthy. S&P 500 companies .SPX expanded their earnings by nearly 37 percent in the fourth quarter, while Q1 earnings are expected at 13.3 percent.
Thomson Reuters data showed private equity-backed M&A activity rose 88 percent on the year to $36.3 billion for year-to-date 2011, marking the strongest annual start for leveraged buyouts since 2008.
German private bank Berenberg says surprises from oil prices and upbeat growth will lead to higher nominal interest rates.
“The two surprises roughly offset each other in their impact on global economic growth. But they do point to less subdued inflation and somewhat higher nominal interest rates,” its chief economist Holger Schmieding said in a note to clients.
Expectations for higher interest rates grew after the European Central Bank warned on Thursday it could soon raise the cost of borrowing. This has sent the interest rate-sensitive two-year German government bond yield to a 20-month high of 1.783 percent.
The ECB’s hawkish stance is raising concerns about the implications for struggling euro zone countries, ahead of a key European Union summit on March 11 where leaders discuss a full package of measures to tackle the sovereign debt crisis.
A failure to agree in principle on measures is likely to trigger a sell-off in peripheral government bonds.
“We are not yet willing to bet on solidarity succeeding. In particular, Spain, Portugal and Belgium have large amounts of debt to refinance in March, April and May and this will be a key test of confidence in these countries,” Dirk Wiedmann, chief investment officer at Rothschild Private Banking & Trust, noted.
“Uncertainty is still as high as ever and we remain cautious. We have low allocations to eurozone bonds, with a focus on higher-quality and short-duration securities.”
Finally, investors may keep an eye on signs of a change in trend in a month which proved a turning point for three of the past 7 years. Most recently in 2009, world stocks rallied 74 percent after hitting a cycle low in mid-March.
Editing by Ron Askew