The Investment Implications of the Oil Slide

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At his press conference on November 2nd, Fed Chairman, Jay Powell opined that the window for a soft landing had narrowed. This was very much in line with his messaging for many months which has emphasized that the Fed regards inflation as being much too high and is willing to put the economy in recession, if necessary, to return it to its 2% target. However, it also underscores the economic problem caused by “supply-shock” inflation: it simultaneously boosts inflation expectations, inducing a more restrictive monetary policy, and drags on economic growth.

Both the economy and financial markets have felt the full impact of supply-shock inflation, and, in particular, oil-shock inflation, in 2022. However, as the year draws to a close, oil prices are tumbling. This actually widens the window for a soft landing and, while we still expect further Fed tightening this week and in early 2023, the oil slide is reducing the risk of either a renewed surge in inflation or deep recession. Because of this, as this blighted year comes to a close, it is worth reviewing why oil prices have fallen recently, what this could mean for inflation, growth and monetary policy in the months ahead, and what it suggests for investor positioning today.

The oil price round trip has been dramatic. According to AAA, the national average price for regular unleaded gasoline this morning is $3.26, down from a peak of $5.02 on June 14th and actually below its $3.33 price of a year ago. Crude oil prices have seen a similar reversal, with a barrel of West Texas Intermediate Crude priced at $70.44 today, compared to $122.11 in early June and $70.86 a year ago.

The reasons for the surge in oil and gasoline prices are well known. Booming economic growth in late 2021, combined with a general global rebound in travel as pandemic effects waned, led to a surge in the demand for gasoline, diesel and jet fuel. Meanwhile, Vladimir Putin’s attack on Ukraine triggered European sanctions and Russian retaliation, reducing the global supply of crude oil and distillate products. This shortage was exacerbated by a decline in U.S. refining capacity and a slowdown in investment in oil and gas drilling during the pandemic.

However, since then, prices have fallen steadily. On the demand side, the global economy has slowed with weakness in Europe, China and the United States all moderating the demand for energy. High energy prices have also induced conservation, with only moderate increases in vehicle miles traveled restraining gasoline demand and higher load factors in the airline industry limiting the demand for jet fuel.  

On the supply side, producers have, not surprisingly, increased output in response to high prices. According to Department of Energy estimates, U.S. production of crude oil and other liquid fuels will top 21.1 million barrels per day in 2023, far above the pre-pandemic record high of 19.5 million barrels in 2019. Other non-OPEC nations are also increasing output and, while OPEC agreed to cut member quotas by 2 million barrels a day in October, there was less to this cut than met the eye as most OPEC members were producing below their quotas. Crude oil prices were further undermined by an OPEC+ decision, on December 4th, not to cut output further.

Other factors have helped depress gasoline prices, including a lack of weather disruption to refineries over the summer, significant releases of oil from the Strategic Petroleum Reserve and very high refinery capacity utilization to try to deal with a diesel shortage. With signs of continued global economic weakness, both oil and gasoline prices could see further modest declines in the months ahead.

The surge in energy prices in early 2022 contributed to a spike in inflation. By June, a 42% year-over-year increase in energy prices had pushed the year-over-year increase in CPI to 9.0%, its biggest increase in over 40 years.

This had two very negative economic effects. First, it spooked members of the Federal Reserve, who seem obsessed with the idea that higher actual inflation could result in permanently higher inflation expectations, making it harder to get back to their 2% target. This undoubtedly contributed to a more hawkish path for interest rates, with four consecutive 75 basis points hikes in June, July, September and November. This, in turn, contributed to much higher mortgage rates, pummeling the housing market, and a much higher dollar, undermining U.S. exports.

It also hurt U.S. consumer confidence, with the University of Michigan’s Index of Consumer Sentiment falling to a record low of 50 in June. This is not surprising – the price of a gallon of gasoline is the best known price in America and in the summer of 2022, a nationwide price of over $5 a gallon seemed to confirm that inflation was out of control.

However, much of this can also work in reverse. On Tuesday, the Labor Department will release CPI data for November and we expect to see a 7.3% year-over-year gain, down from 7.8% in October. Moreover, lower gasoline prices over the winter, along with fading inflation elsewhere, could easily cut the headline inflation rate to between 6.5% and 7.0% in December, 4.5% to 5.0% by March and to between 3.0% and 3.5% by this time next year.

Lower energy prices could also help economic growth by bolstering real consumer income, particularly for lower and middle-income households. Even with this, we expect that real consumer spending will grow very slowly at best. However, cheaper oil clearly reduces the risk of a hard landing.

This risk would be further reduced if the Federal Reserve were willing to accept the gift being presented to it by oil markets. While there is little evidence that significantly higher inflation expectations are getting embedded into the economy, the slide in oil prices should alleviate that worry anyway. 

This Wednesday, the Federal Reserve will very likely announce a 0.50% increase in the federal funds rate, moderating the pace of increase from the last four meetings. They will also provide new forecasts for the federal funds rate which we expect to imply a total of 0.50% more in rate increases in early 2023, bringing the terminal rate to a range of 4.75% to 5.00%. 

This is probably more restraint than the economy needs. The yield curve, as measured by the spread between two-year and ten-year Treasury yields, is at its most inverted since 1981, indicating expectations of both lower inflation and recession. The gap between five-year nominal Treasuries and five-year TIPS, which provides a forecast of CPI inflation rate over the next five years, has fallen from 3.6% at its peak last March to 2.3% today. And futures markets suggest that investors expect the Fed to reverse course, cutting rates later in 2023 and in 2024.

It would be better for the economy if the Fed avoided the mistake of being too tight. However, if they don’t and the economy falls into stagnation or recession, the downturn should be milder because of cheaper oil. Moreover, lower oil prices increase the chances that we will emerge from the rollercoaster of the past few years with a slow-growth but low-inflation economy. This should serve as a solid foundation for good returns for both stocks and bonds after a very difficult 2022. 

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