Market Perspectives October 2023
Read our latest round-up of the global themes, trends and events influencing investors.
Dorothée Deck, London UK, Cross Asset Strategist; Lukas Gehrig, Zurich Switzerland, Quantitative Strategist
Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.
Oil prices have climbed by almost 35% in the past three months, reaching a 10-month high of $96 a barrel late September. If sustained, high energy prices could hit economic activity and derail the recent deceleration in inflation seen in many large economies. This development threatens the ‘soft-landing’ narrative, which has become the consensus view in financial markets.
It also represents a new challenge for central banks, as they consider ending their monetary tightening cycles. With equity valuations looking stretched following the strong rally in share prices seen in the past year, we consider the potential impact of a sustained rise in energy prices.
Oil prices have soared on tighter supply/demand dynamics, after Saudi Arabia and Russia extended voluntary production cuts until the end of this year, while demand for the commodity was better than expected. Indeed, global oil demand has reached an all-time high, boosted by strong summer air travel, increased oil use in power generation and surging Chinese petrochemical activity.
There is now a substantial deficit in oil markets, which is likely to persist into the fourth quarter of this year, according to the International Energy Agency (IEA)1. The agency estimates that unwinding the voluntary cuts at the start of 2024, would shift the balance to a surplus. However, oil inventories would be at uncomfortably low levels, increasing the risk of another surge in volatility.
Saudi Arabia's energy minister Prince Abdulaziz bin Salman defended the Kingdom’s decision to extend production cuts, in a move intended to stabilise markets and prevent volatility in the face of inconsistent global demand, as opposed to raising prices.
In order to assess the potential impact of higher energy prices on equity markets, the following factors should be considered: 1) the speed and magnitude of the moves, 2) how long price hikes are sustained for, and more importantly 3) the drivers behind these moves.
Over time, equities and oil prices generally move in the same direction. Since the global financial crisis, in 2007/08, stock returns have broadly been positively correlated with the price of oil, as gently rising oil prices have tended to coincide with periods of stronger economic activity (see chart).
Six-month change in global equity prices and oil prices over the past 20 years, and rolling three-year correlation of six-month changes
Significant equity market sell-offs have often followed sharp and sustained increases in the oil price. The chart below shows that a doubling in the oil price over a two-year period has often had a negative impact on equities, in absolute terms and relative to bonds That said, the experience of 2005-06 was an outlier.
The grey shaded areas in the chart represent times when the oil price more than doubled over a two-year window. Those periods were generally followed by sharp declines in global equity prices and stocks underperforming bonds.
This highlights that economies can generally deal with significant increases in energy prices (even when driven by supply factors), as long as they are introduced gradually or do not last for very long. If given enough time to adapt, companies and households can generally absorb higher energy costs. However, unexpected price increases, when sustained, can have a negative impact on global growth.
Global equities total-return index and two-year percentage change in the oil price
As discussed in last year’s How much do oil shocks really affect equity markets, supply-driven oil shocks have tended to be more damaging, and have often led to recessions, in the past. The analysis identified ten supply-driven shocks over the past 50 years (excluding the most recent one), which lasted five months on average, and peaked at a 79% increase over the starting price.
Using data from the Federal Reserve Bank of New York’s oil price dynamics report2, we would categorise the recent episode as a supply shock. We estimate that over 75% of the increase in the oil price in the months of July and August can be attributed to supply factors, with only 25% attributed to demand factors.
Global equity markets have typically troughed seven months after the start of a supply-driven oil shock, with an average drawdown of -7%, before recovering their losses within 14 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%.
Distribution of global equity returns in the months before and after supply-driven oil shocks
Unsurprisingly, the energy sector was by far the best performer globally in the year following the start of an oil shock, outperforming the market by 18% on average (see chart). Basic materials, another commodity-driven sector, beat the market by 5% on average over the same period.
As global activity generally deteriorated in the year following those shocks, it is not surprising to see that defensive sectors, such as utilities and healthcare, outperformed by 6% and 5% respectively in the subsequent 12 months. Meanwhile, financials outperformed by 4% on average in the following year, supported by higher yields and inflation.
In contrast, technology was by far the main laggard, underperforming the market by 11% on average after 12 months. 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 5% and 4% respectively after 12 months. This probably reflects lower consumer spending 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.
Average relative performance of global equity sectors 12 months after the start of supply-driven oil shocks, and relative performance since 27 June 2023
While it seems premature to assume that the recent surge in energy prices is here to stay, it is a risk that should not be ignored, as demand and supply dynamics are highly uncertain.
For now, most participants seem to assume that the oil price will moderate. A Bloomberg consensus of analysts expects Brent oil to average $86 a barrel in the fourth quarter this year (versus $96 at present), and $88 in the fourth quarter next year (within a range of $75 to $106 a barrel).
However, investors trying to limit the effects of a sustained rise in energy prices on their portfolio could consider a number of possible strategies in equity, currency and commodity markets.
Within the equity market, as discussed earlier, energy stocks are well placed to benefit from higher oil prices. Despite a 17% outperformance since mid-July, the sector still lags its relationship with earnings. The sector appears cheap, trading at a significant discount to the market relative to history (on a -37% relative price-earnings (PE) discount against the 20-year average of -12%), with a superior dividend yield (4.1% forward dividend yield for MSCI All Country World Energy versus 2.3% for the market as a whole). It also represents an attractive hedge against inflation and geopolitical risk.
Basic materials are another possible hedge, although it is not as cheap as the energy sector and is more vulnerable to weaker Chinese growth. The sector is very sensitive to the country’s economy and it has underperformed the market year-to-date, as Chinese economic activity has underwhelmed. So far, the authorities have announced piecemeal stimulus measures in an attempt to stabilise the economy, but a more sizeable and targeted package may be needed for the sector to re-rate materially.
Within currencies, oil and gas exporters stand to benefit from higher energy prices, especially currencies such as the Norwegian krone (NOK), the Canadian dollar (CAD) and the Australian dollar (AUD). Petroleum products represent approximately two-thirds of Norwegian exports, over 20% of Canadian exports and over 10% for Australia. Therefore, their terms of trade generally improve when oil prices rise, lifting demand for their currency. Since the global financial crisis, the NOK/USD, CAD/USD and AUD/USD have had a strong and relatively stable correlation with the oil price, with correlation coefficients of +73%, +75% and +66% respectively.
Finally, within commodity markets, our analysis shows that gold performed well in the months following oil-supply shocks. On average, the precious metal had climbed by 9% six months after the shocks started, and was up by 20% after a year and 33% after 18 months. As such, gold was an efficient diversifier in multi-asset portfolios when equities were weak. As inflation, recession and geopolitical risks persist, this is likely to remain the case. However, relative to real yields, gold appears fundamentally expensive. This is why gold should be considered more as a portfolio diversifier at present, than a source of upside.
While most forecasters expect the oil price to moderate this year, the risks seem to be tilted to the upside. If sustained above $90 a barrel, the oil price poses the risk of slower global growth and higher inflation. If the soft-landing narrative for the global economy is challenged, equity markets look vulnerable to a retreat.
In the current environment, energy stocks, select ‘oil currencies’ and gold seem to be attractive hedges for multi-asset investors wishing to insulate their portfolios against a sustained rise in energy prices.
Read our latest round-up of the global themes, trends and events influencing investors.