Markets in general had a decent week. Yes, there was volatility but as of Friday’s close, the S&P ended the week up +2.2%. Despite growth stocks getting clobbered on Friday (the NASDAQ was down -1.7%), their return for the week was +1.3%. The only two major asset classes to suffer meaningful weekly losses were emerging market stocks and commodities (more below), down -2.5% and -1.2% respectively.
Oil’s Fall From Grace
WTI Crude Oil hit a bear market this week, down over -20% from its October high as you can see below.
What happened? According to Bloomberg, the median analyst forecast for oil prices at year end is $78 a barrel, so this sharp downtrend likely caught many industry experts by surprise. A few factors seemed to have caused the collapse:
1) US crude production is at a record
2) OPEC output has increased drastically during the second half of this year and is at the highest level since 2016 (which were the highest levels on record).
3) This week the Trump administration announced the details of a sanctions package on Iran and despite the harsh rhetoric, waivers were granted that allow a good chunk of Iranian crude oil to make it to the markets. In fact, seven of the top 10 importers of Iranian oil will be exempt from any restrictions on purchasing.
So, what are the knock on effects of an oil bear market? We’d argue that a sustained period of depressed oil prices would help keep inflation in check. In fact, the Fed published a study last year analyzing the effects of large changes in oil prices on core inflation (i.e. inflation ex-food and energy). Their findings essentially state that because oil is such a key input to the global economy, even a short period of oil price distortion can lead to small but lasting changes in core inflation. And while over the long-term these changes tend to be small, short-term fluctuations can be meaningful. Below is a chart from a study the IMF did on this topic. It shows the inflation effects of a 1% change in oil price inflation years after the change. The key takeaway: changes in oil prices matter to inflation, even inflation that doesn’t include the price of oil.
While this whole dynamic isn’t top of mind for us, it’s certainly something we’re aware of. Core inflation is the Fed’s key measure of price stability and anything that affects it will surely get some attention at this stage in the economic cycle.
Will an oil bear market lead to a huge drop in inflation and the Fed pumping the breaks? Probably not, but it’s worth keeping an eye on.
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