Economies, and financial markets, face an oil shock. Oil prices and equity returns have typically moved in opposite directions in the past, when supply factors drove extreme increases in energy costs. This article identifies supply-side oil price shocks and what they mean for equity investors, based on the last 50 years of data. Despite the recent sharp spike in oil prices, there are reasons to believe that many developed market economies are more resilient to oil price shocks today than they were in previous decades.
Oil prices are seven-times higher than they were two years ago. Volatility is high, with the price of Brent crude moving from $97 a barrel on 24 February, before the invasion of Ukraine by Russia, to $128 on 8 March, then dipping below $100 in mid-March, only to shoot above $120 again towards the end of March.
The situation between Russia and Ukraine remains highly unpredictable, and until there is more clarity on the geopolitical front, energy prices, and commodities in general, are likely to remain highly volatile.
More to the point, if the energy crisis deepens or becomes more entrenched, it may trigger a recession. The growth/inflation dynamics had already started to deteriorate in December, after leading central banks took a more hawkish stance. The invasion of Ukraine further exacerbated those risks.
The longer that energy prices remain elevated, the more likely they are to impact growth, through lower disposable incomes, weaker corporate margins, reduced or delayed capital expenditure programmes, and ultimately higher unemployment.
The speed and magnitude of energy price increases matter, as well as their drivers
Since the global financial crisis in 2007/08, equity returns have generally been positively correlated with the price of oil, with gently-rising energy prices tending to coincide with periods of stronger economic activity. However, sharp and sustained hikes in the cost of oil have often led to recessions, especially when they were driven by supply shocks, as seen since late December.
While it is impossible to predict how the situation in Ukraine will change, or how long it will last, it is a risk that cannot be ignored. We explore how financial markets have behaved in supply-driven shocks in the past (excluding the current one), and highlight which areas of the market have been the best and worst performers.
While most of the increase in the oil price since April 2020 was driven by a recovery in demand, as the economy reopened after pandemic lockdowns, the most recent spike, from late December to early March, was mostly driven by supply factors, according to data from the Federal Reserve Bank of New York (New York Fed). Market prices reflected fears that the oil supply could be disrupted, rather than an actual drop in production.
During this short 11-week period, the price of Brent surged by 73%. Predominantly supply-driven shocks this large are scarce. The last was in the Gulf War in 1990. In order to include both sizeable and more recent shocks in the following analysis, our required minimum cumulative price increase was set to 20%.
Identifying and classifying supply shocks
In our analysis, to identify oil supply-shock periods, we computed cumulative price increases until a peak or plateau was reached. If the front-month contract price for Brent lay at or below the value ten days prior, we stopped measuring the cumulative increase and restarted at 0%. For an additional robustness check, we ran this analysis on both Brent and West Texas Intermediate prices, and excluded shocks that were only observed in one data series. These consolidated increases of over 20% were then combined with data from the New York Fed’s oil price dynamics report.
The report uses market data at daily frequency intervals to break down oil price moves. The idea is to use market background knowledge to classify shocks. For instance, during a supply-driven shock, currencies of oil importers tend to depreciate and cyclical stocks generally underperform defensive stocks. However, demand shocks tend to be accompanied by higher interest rates and the depreciation of safe-haven currencies.
“Shock” periods were classified as supply-driven ones when the New York Fed model attributed at least two-thirds of the increase during the identified shock periods. While the New York Fed data is not available for 1973 and 1979, these oil shocks are well known to have been caused by supply restrictions following conflicts. This left us with ten supply-driven shocks, which on average lasted five months, and peaked at a 79% increase over the starting price (see chart).
Typical impact of supply-driven shocks on the economy
Unsurprisingly, we found that the macro environment generally deteriorated during supply-driven oil price increases. The Institute for Supply Management manufacturing index typically declined from 55.0 at the beginning of the rise in oil prices (t0), to 48.2 after nine months (t+9m), recovering thereafter to 52.5 after two years (or at t+24m). The annual change in the US consumer price index rose from 4.3%, on average, at t0, to 5.5% at t+6m, before trending down to 4.7% after two years.
By contrast, the US unemployment rate steadily deteriorated over the period studied, from 5.3% on average initially, to 6.7% at t+24m. Similarly, the US 10-year Treasury yield rose by some 120 basis points over the same period. Such a move would obviously have bigger repercussions with a starting point at 2% compared to 10% or 15%.
In a better place to deal with the crisis, this time
There are several reasons why the global economy is probably more resilient today than it was back in the 1970s and 1980s. Yet, the geopolitical situation complicates the environment, and adds to the level of uncertainty.
- The world is significantly less energy intensive than it was in earlier decades, especially in advanced economies. Today, for example, the US generates almost three times as much output for every unit of energy consumed than it did in 1970. For Europe, that figure is more than two times
- Economies have also come into this supply-shock crisis with strong economic momentum and above-trend growth
- In addition, US and European consumers have accumulated large excess savings, following the fiscal support provided to people during the coronavirus pandemic. This means that they should be able to absorb higher energy costs more easily
- And finally, we see the potential for more fiscal measures to mitigate the impact of high commodity prices on the consumer
Typical impact on markets
Global equity markets typically troughed seven months after the start of a supply-driven shock, with an average drawdown of -7%, before recovering their losses within nine months (see chart).
The worst individual drawdown was seen in March 2009, when equities fell 52% from the start of the previous shock in April 2008. However, this was at the low point of the global financial crisis, a period when equity markets were driven more by the financial crisis than the preceding oil shock. The second-worst drawdown was seen in October 1974, 16 months after the start of the shock, and saw global equities decline by -39%.
Gold tends to perform well in oil supply shocks
Historically, gold has been a very strong performer in the months following oil supply shocks (see chart). On average, the precious metal climbed 25% 12 months after the start of the shocks (t+12m), and was up by 39% at t+18m. The price of gold peaked at +42% on average, 20 months after the start of the shocks.
As such, gold has acted as an attractive hedge in multi-asset portfolios, when equities were weak. Seven months after the start of the shocks, when global equities were at their average low point (down -7%), gold was up +7%.
Copper generally outperformed global equities in the year following a shock (up +12% at t+12m), but it was a less consistent diversifier and significantly underperformed gold.
Sectoral trends during oil supply shocks
Unsurprisingly, the energy sector was by far the best performer globally in the year following the start of a shock, outperforming the market by 15% on average. As a commodity-driven sector, basic materials also outperformed, by 5% on average, over the same period (see chart).
As global activity generally deteriorated in the year following those shocks, we were not surprised to see defensive sectors, such as healthcare and utilities, outperform by 6% and 5% respectively after 12 months. Financials outperformed by 4% on average, in the subsequent year, supported by a rise in yields and inflation.
In contrast, technology was the main laggard, underperforming the market by 11% on average at t+12m. The sector tends to underperform in periods of rising yields, due to the long duration of its cash flows.
Consumer staples and consumer discretionary were also notable underperformers, lagging the market by 7% and 4% respectively after 12 months. This probably reflects lower consumer spending activity and weaker corporate margins. Disposable incomes were squeezed by higher commodity prices, while some companies were unable to pass on higher input costs to their customers.
Putting the recent shock in context and sector preferences
The most recent oil supply-shock was severe, both in term of its magnitude and its impact on markets. At the height of the oil shock on 8 March, the global equity drawdown was slightly worse than seen in similar periods in the past (-10% versus -7% on average at the point of maximum drawdown) and the price of gold had appreciated by 15%. Since then, however, global equity markets have recovered and, at the time of writing, were close to their average performance in previous supply shocks.
The sector rotation since the start of the last shock, on 21 December, has been broadly in line with historical trends in the year following the shocks (the magnitude of the moves cannot be compared as the length of the periods differs). The best performing sector globally was energy, and the worst one was technology. Basic materials, utilities, and financials all outperformed.
We continue to prefer sectors that should profit from higher yields, inflation, and commodity prices, namely financials, industrials, and basic materials. We have become more neutral on energy, following its strong run of late, as other cyclicals seem to offer more value at this point. However, some residual exposure to energy may be kept in the near term, as a hedge against geopolitical risk.
We also reiterate our positive view on the healthcare sector, as history shows that it has outperformed following oil supply shocks. The sector has not reacted yet, and is slightly down relative to the market in the most recent event. However, we note that in previous periods, the sector generally performed in line for the first six months, and then really started to outperform after nine months, as the economic environment deteriorated.
We remain cautious on technology, consumer staples, consumer discretionary, and telecoms, given their historical performance in previous shocks and their negative correlation with yields.