What has oil prices been rising?
As with any asset price, oil is driven by supply and demand.
On the demand side, oil was impacted by a slowdown of global growth, driven in particular by China and other emerging markets, from 2014 to early 2016.
On the supply side, Saudi Arabia made a strategic decision to flood the market in an attempt to regain market share—lowering the price via increased supply to make higher cost US shale oil companies sufficiently unprofitable to cease production.
Finally, the 25% gain in the trade-weighted dollar over this period also weighed on the commodity. The rebound in oil over the last two years largely reflects an unwinding of these conditions. The global economy rebounded sharply over the course of 2016, supported by Chinese stimulus and extraordinarily easy monetary policy from developed market central banks. Meanwhile, domestic considerations led Saudi Arabia to not only reverse its own policy of oversupply, but spearhead an OPEC+Russia agreement to cut production sharply.
Dollar strength has partially unwound, which has also boosted oil.
Will higher oil price mean a faster pace of Fed tightening?
An oil price rise is a tax on consumers in oil importing developed economies and a windfall for major oil producing countries, many of which are emerging markets. Prices of ‘at the pump’ gasoline have risen steadily in the US, which was part of the reason for softer consumption in US Q1 GDP.
But as the shale revolution has made the US one of the world’s largest oil producers, energy has become an increasingly important part of the US economy, driving employment and capital expenditure. Moreover, tax cuts are starting to boost disposable incomes, which should cushion the negative impact from higher energy costs. And while the oil price rise is filtering through to higher headline inflation, it is excluded from the Fed’s preferred Core Personal Consumption Expenditures index.
As an input cost across industries, there will almost certainly be some pass-through of higher oil prices to core measures, but the Fed is likely to look past higher energy costs and focus on the trend in less volatile underlying inflation. As such, we do not see the rise in oil prices as automatically leading to a faster pace of Fed tightening.
US has become a major oil producer
So have higher oil prices impacted investors?
Higher oil prices have been a key driver of government bond market volatility and as a byproduct, much of the equity market volatility observed this year.
However, when breaking down interest rates into key components of real yields and expected inflation rates—often referred to as ‘breakevens’—we find that higher oil prices explain much of the rise in breakevens.
Oil explains much of the rise in inflation breakevens
This makes sense, as investors in inflation-protected US Treasuries are insulated from gains in headline, as opposed to just core inflation. And while real yields rose to start the year, largely reflecting the effects of expansionary fiscal policy in the US, they are generally in the range they’ve been in for the past five years.
Thus, even though nominal yields have risen, there has not yet been a sufficiently meaningful tightening of financial conditions resulting from higher rates to believe a US recession or a major drawdown in equity markets is imminent.
Recent major bear markets in equities tend to require a convergence between real GDP and real yields. Higher oil prices are not likely to drive the former much lower nor the latter much higher. In short, while we do see further potential downside to bonds from higher oil prices via higher breakevens, we do not see it as a meaningful threat to global equities.
The bottom line: asset allocation
- While energy prices can remain elevated near-term, we suspect that ultimately US production will ramp up further and Brent oil will stabilize in a USD 60 to 80 range.
- The rise in oil prices is consistent with our underweight in global duration.
- At this point we do not expect higher oil prices to negatively impact growth in developed markets enough to shift our equity overweight.
- Oil sensitivity in emerging markets differs by region and by country, but in general the rebound in commodities should support broad-based EM asset strength.
- Yet independent of forecasts for any particular commodity, exposure to commodity-linked assets can provide useful diversification benefits for multi-asset investors late in the economic cycle.
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