By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company
Looking at today’s economic headlines, you might wonder if it’s 2012 or whether the timeline slipped backwards a year. In many crucial areas – rising inflation, slowing economic activity and the ongoing European sovereign debt crisis – it may seem like we’re still in the spring of 2011. Just like last year, the economic recovery that seemed so promising in the winter months is in danger of stalling out. Gas prices and overall inflation are threatening to derail the economy just as job growth, consumer spending and consumer and business confidence are poised to break out on the positive side.
Much of the recent pessimism both from economists and consumers surrounds gas price increases. During mid-April, average prices at the pump came at $3.91, according to AAA’s Daily Fuel Gauge Report. Prices are about where they were a year ago; they fell to a low of $3.25 a gallon in December, then started going back up again.
Oil prices are likely headed higher, at least in the short term. Summer is a prime time for travel, so gas prices at the pump tend to be higher. Add in capacity limitations at U.S. refineries, Iran-related problems, the upcoming summer driving season and supply-demand problems and it’s not likely that oil prices or gas prices at the pump will be headed down anytime soon.
Downstream, price trends are trending up as well, with refinery capacity constraints, limited global oil supplies and strong demand from the developing and the developed world all working in concert to keep prices higher at least in the near term. That’s the focus of this month’s commentary – we’ll discuss the impact of higher oil prices on the economy and the stock markets, whether the increase in prices is due to fundamental supply and demand issues or stems from geopolitical and seasonal issues and some thoughts on where we are headed.
Increases in oil prices impact the economy in a number of ways. The major impact of oil price inflation – especially dramatic rises in gasoline prices – is that consumers direct more of their discretionary spending towards filling their gas tanks and less on other types of spending that could fuel economic growth. For businesses, higher gas prices mean lower profits, which result in lower output of goods and services and reduced capital investment. Lastly, governments are affected by lower tax revenue that results from lower business profits and less consumer spending – typically, in this kind of scenario, budget deficits increase, spurring borrowing and higher interest expense.
In terms of impact on gross domestic product (GDP) – the most widely followed measure of economic growth – U.S. GDP during the past five years averaged 2.2 percent; that growth rate would have been .3 percent higher if oil prices had stayed lower (fig. 1). So, a $10 increase in the price of a barrel of oil shaves .3 percent off GDP.
Besides oil prices, food inflation has been picking up recently. Globally, food prices rose for a third consecutive month in March boosted by shortages of key grains, including soybeans, corn and wheat. Oil price inflation is strongly correlated with food inflation because energy prices impact the prices of fertilizers used to cultivate food and food distribution, as well as farm machinery utilization.
Circling back to the impact of higher oil prices on consumers, increases in gasoline prices tend to force consumers to cut back on other discretionary spending. Like paying a mortgage or spending on health care, gasoline, especially when used to commute to work, is an expense that consumers have to grin and bear, because there aren’t many other options.
Despite the generally negative impact on consumer discretionary spending, in some ways consumers are in better financial shape to withstand higher oil prices than they were last year or a few years ago. Not only has the housing market slowed its freefall, but consumers also have more access to credit and the job market is showing improvement. In addition, lower natural gas prices mean a decline in gas and electric bills, which can somewhat offset higher prices at the pump (fig. 2).
During the past several years, the S&P 500 and oil prices have been pretty closely correlated (fig. 3). As oil prices go, so goes the S&P 500. During a time of rising equity values, oil prices have also gone up. It’s counter-intuitive to a degree, and there’s a lot of disagreement about the relationship and the causes of the relationship.
Typically, rising oil prices tend to depress stock prices, because rising oil prices eventually depress economic growth. However, some analysts argue that stock prices have continued to increase because oil price increases are based on fundamental improvements in economic prospects in the U.S. rather than speculation or political factors, such as Iran.
If inflation, driven by oil and food prices, increases much beyond 3 or 4 percent, the Federal Reserve will be in a bind. The Fed’s stated policy is to keep interest rates extremely low through the next year or two in an effort to stimulate the economy, specifically job creation. But if inflation stays high, the Fed will need to think twice about increasing interest rates to stem inflation. Some economists believe that the Fed’s long-term easy money policy has set the stage for inflation by pumping excessive amounts of money into the financial system. Low interest rates have been beneficial for the stock market, because investors are forced to put more of their money into riskier assets since they can’t get much yield through traditional fixed income investments, such as bonds, bond funds and certificates of deposit. If interest rates and inflation increase and stay elevated, it will most likely be a negative for the stock market because assets will move away from the stock market into fixed income instruments and inflation will crimp economic growth.
There’s no doubt that tensions surrounding Iran are fueling recent oil price spikes. Just as last year’s unrest in the Middle East sparked price increases, with uprisings in Egypt, Libya and other countries, this year Iran’s apparent determination to continue with its development of nuclear capabilities is weighing on oil prices and oil price futures. Western sanctions against Iran due to its nuclear activities have cut the amount of Iranian oil in the global markets, which has led, and will likely continue to lead, to higher oil prices. Iran is the third largest oil producer in the world and the second largest producer within OPEC.
Oil refineries, which represent a critical link in the oil supply chain, are another emerging problem figuring into oil prices and oil and gasoline supply and demand dynamics. During the next couple of months, it’s very likely that close to 50 percent of the refining capacity on the east coast will be shut down or already has shut down. According to the oil refinery companies that operate these facilities, these older refineries don’t have the capability to process heavier types of oil that represent a higher proportion of the oil supply. Oil refinery companies are reluctant to build new refineries, citing burdensome regulations.
Speculation is also thought of as another possible factor moving oil prices higher. The Fed’s moves to keep interest rates at extremely low levels have driven assets into equity and commodity markets, and, in fact, to any asset that doesn’t bear interest directly. Recently, economists at the Federal Reserve Bank of St. Louis estimated that speculation on Wall Street is currently the second-largest contribution to oil prices, adding 15 percent overall to the price of oil in the past 10 years. Hedge funds, major financial institutions and individual speculators have ramped up activity in the futures market to the point where President Obama is asking Congress to crack down on rogue traders by vastly increasing penalties for energy market manipulation, beefing up enforcement by the US Commodities Futures Trading Commission (CFTC) and empowering the CFTC to raise margin requirements in the futures markets, which could curb oil prices speculation.
The U.S. dollar tends to be affected by rising oil prices for several reasons. First of all, because the U.S. imports a lot of oil, the U.S. economy is more economically vulnerable to oil price increases. The dollar tends to fall in value because the United States is spending more dollars on importing oil; continued weakness in the dollar then translates into higher oil prices due to parity relations, which lead to further downside pressure on the dollar. That decrease in the value of the dollar leads to a deterioration in the balance of payments, which leads to even more pressure on the dollar. That, in turn, adversely impacts the economy. On a global macroeconomic level, the correlation between a falling dollar and rising oil prices reflects a weaker U.S. and developed market economies and stronger developing world economies. Since the beginning of the financial crisis in 2007, Central Banks have vastly expanded their balance sheets. The Fed pumped liquidity into the system throughout the financial crisis and has continued since the crisis ended to attempt to stimulate the economy through two rounds of quantitative easing. In Europe, the European Central Bank (ECB) has engaged in several long-term financial operations – known as LTRO – in an effort to prop up debt-laden countries on the periphery of Europe, most recently Spain and Italy (fig. 4).
Through these efforts, the Fed’s balance sheet has more than tripled to nearly $3 trillion as of April 2012. The Bank of England has also engaged in fiscal stimulus, as its balance sheet as a percentage of GDP is now higher than the Fed. The ECB has been extremely aggressive in its efforts to prop up the Eurozone economy and contain the sovereign debt crisis in Europe, which has resulted in a balance sheet as a percentage of GDP that is the highest in the developed world, higher even than Japan, which has tried to use fiscal stimulus to elevate the country out of the persistent deflation it’s experienced for the past two decades.
Two bright spots in the current oil price environment are declining consumption in the developed world just as fuel efficiency in vehicles is also continuing to increase. According to the Organization for Economic Co-operation and Development (OECD), oil consumption has been declining, albeit slowly, since 2007. It’s likely that higher oil prices are affecting consumption, especially in Europe, where already high gas prices at the pump are impacted further by the weak Euro. Consumption patterns are increasing in the developing world, which is also more resilient financially than the developed world, due to less debt and faster growing economies.
In terms of increased vehicle efficiencies, new car fuel economy in the U.S. reached a record high this Spring as more consumers than ever before choose fuel efficient vehicles over less efficient vehicles. According to the University of Michigan Transportation Research Institute, the average fuel economy of cars sold in February was 23.7 miles per gallon. Going forward, fuel economy will continue to increase, as the Obama administration is proposing average fuel economy rates of 40 mpg that car manufacturers would have to meet by 2025.
Oil price trends are a key variable as is inflation. Keep an eye on the prices of West Texas Crude and North Sea Brent; sustained price levels over $110 for West Texas Crude and above $125 for North Sea Brent will likely translate to gas prices of more than $4 a gallon during the summer months in the U.S. And while consumers may have more stomach for higher gas prices, at a certain point they will drain discretionary spending from the economy at a time when it’s needed.
Inflation is another key metric. The Fed is committed to keeping interest rates low, but may be challenged in this regard if inflation moves and stays higher. The consumer price index, especially the core inflation statistics, are important in this regard. And obviously, the growth of the entire economy is dependent upon the job market continuing to improve as well as the housing market, retail sales and consumer and business sentiment.
It’s likely that oil prices will stay at the levels we are seeing now, or somewhat higher, at least through the end of the summer, if not through the end of the year. And that’s absent a financial or geopolitical shock. If tensions with Iran worsen or refinery or other supply problems occur, gas prices could go significantly higher. Some economists argue that the stage is set for oil prices to increase 10 percent or so above where they are now and stay there through the second and third quarter of 2012.
Although the Federal Reserve is indicating that it will not be injecting monetary stimulus in the near future, the markets are hopeful that the FED will in fact embark on another round of quantitative easing, buying bonds to inject more money into the financial system to lower interest rates and spark economic growth. Such “QE” moves in the past have been associated with increases in the stock markets.
In Europe, more rounds of long term refinancing operations (LTROs) have been designed to prop up ailing national bond markets in Italy and Spain, the next two wavering dominos in the periphery of Europe. How much more the European Central Bank can do – and is willing to do – to support the economies and banks in an open question, but the markets are hoping that if another LTRO is implemented, markets will see another significant gain as they did during the most recent round.
Finally, the odds of another crisis in Europe are higher. Spain and Italy have much larger economies and much larger bond markets than Greece and the consequences of those two countries being unable to issue bonds if national interest rates increase is extremely troubling. Europe is already in a recession, and the lack of confidence in Spanish and Italian governments, bonds and banks won’t make it any easier for Europe to climb out of its self-induced sovereign debt crisis. The problems in Europe, like rising oil prices and inflation in general, provide a headwind that the economies in the rest of the developed and developing world don’t need if the ongoing economic recovery is to finally gain traction.
Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.
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The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system.
The Organization for Economic Cooperation and Development (OECD) is an international economic organization of 34 countries founded in 1961 to stimulate economic progress and world trade.
S&P 500 is maintained by the S&P Index Committee, a team of Standard & Poor’s economists and index analysts, who meet on a regular basis. The goal of the Index Committee is to ensure that the S&P 500 remains a leading indicator of U.S. equities, reflecting the risk and return characteristics of the broader large cap universe on an on-going basis. The Index Committee also monitors constituent liquidity to ensure efficient portfolio trading while keeping index turnover to a minimum.
The Organization of the Petroleum Exporting Countries (OPEC) is a permanent intergovernmental organization of 12 oil-exporting developing nations that coordinates and unifies the petroleum policies of its Member Countries.
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