Energy Price Shocks are so 1970s

Natural gas shortages in Europe and Asia have dominated the headlines over the past week, injecting a fresh bout of anxiety into the markets. With fossil fuel prices at record or multi-year highs, market participants are worried about the prospects of stagflation. Energy experts are debating the challenges of transitioning to renewables while the world remains dependent on fossil fuels. Consumers fret about facing significantly higher electricity or heating bills in the event of a colder-than-expected winter. But even though energy prices are another risk to monitor in the near-term, we do not foresee a 1970s type scenario playing out where growth slows sharply, inflation becomes problematic, and markets sell-off meaningfully as a result.

This is not your 1970s US economy

The good news is that the US, as a net energy exporter, is much less vulnerable to fuel shortages than other regions of the world. The shortages are more acute in Europe and China. However, soaring prices in the rest of the world make US exports of natural gas attractive, pushing prices higher. US natural gas prices are up more than 150% this year, the highest level since 2014. Still, we expect prices will level off as we move into 2022, driven by higher domestic production.

It is also worth noting that the impact on GDP and inflation from higher energy prices is less than in the past. Energy intensity (units of energy per unit of GDP) of the US and other advanced, service-based economies has been steadily declining for decades. The oil intensity of global GDP, for example, has dropped by 25% since 1990 (and by more than 50% since the early 1970s when oil price shocks caused recessions).

On the consumption front, in the US, gasoline accounts for 2.35% of personal consumption expenditure, according to Bureau of Economic Analysis data. That is down from 3.26% in 2014 (when oil prices were also around USD 80/ bbl).

That said, the risk to our view is a colder-than-average winter that could lead to a higher than normal demand for natural gas exacerbating the supply shortages in China and Europe. Demand for electricity is price inelastic so prices of coal and natural gas could rise to the point of triggering factory shutdowns or government-forced blackouts, which could hurt output. Production disruptions in China/Europe could further disrupt supply chains and a slowdown in growth in China or Europe would mean less demand for US goods and services from those regions. Even so, we would expect slower growth in the US in such an event, not a recession.

US markets are not overly vulnerable

From an earnings perspective, rising energy costs in itself does not dim the outlook for earnings. After all, the cost of commodities account for only about 5% of S&P 500 sales. And profit drivers remain solid. Consumer spending should remain well-supported by a growing jobs market and rising wages. Businesses are also spending in order to expand production and rebuild inventories. Leading indicators such as the ISM Manufacturing index confirm the favorable view. Supply chain disruptions are causing headaches for some companies, but the bottlenecks should prove temporary as COVID-19 waves in Asia improve and West Coast port congestion starts to ease now that the peak import season is behind us. Continued growth in corporate profits should drive further gains for US equity markets.

The US energy sector has been benefitting in 2021 from increasing energy demand, an under-supplied oil market managed by OPEC+, rising crude oil and natural gas prices, newfound capital discipline among US on-shore producers, and improving return to shareholders in the form of higher dividends and share repurchases. The earnings and cash flow recovery in the sector should continue into 2022, assuming capital discipline continues. Natural gas focused companies have more infrastructure constraints but are benefitting from higher prices, increasing demand including rising LNG exports, and similar capital discipline.

We continue to have a Most Preferred view on the energy sector, which remains supported by valuation, our outlook for stable oil prices (weather normalized) and improving energy demand. At current valuations, energy equities are discounting crude oil prices of about USD 55-60 per barrel.

What should you do?

The probability of stagflation has increased with the recent surge in fossil fuel prices adding to other inflationary pressures, but it still remains unlikely, in our view. We continue to believe inflation pressure will ease, although they are lingering longer than expected. We expect supply chain issues, which are mostly due to elevated demand for goods, to abate as the economy normalizes and consumption shifts back from goods to services. Our base case is for inflation to stay elevated until end of 2021 before gradually falling towards 2% by mid- 2022.

We believe positioning for reflation is still the right tactical strategy, which favors value stocks, commodities, and senior loans in credit as rates continue to rise. These assets should do relatively well, regardless of whether the macro environment is closer to reflation or stagflation although the absolute level of returns could be quite a bit lower under stagflation. We do expect more volatility in the near term, however, until clear evidence emerges in favor of reflation.

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