Could Oil Price Levels Cause a Recession?
Car enthusiasts will tell you that driving a car with a manual transmission is more fun. The driver feels more connected to the vehicle and is more aware of changes in road conditions. As long as the road is dry and flat, it is a fairly simple task. However, when travel conditions are slippery or one is faced with an incline ahead, it takes more skill to prevent the engine from stalling. We believe this analogy fits today’s economic environment as rising oil prices could stall growth in the coming months, and we must adjust our driving style to navigate changing conditions.
Recession fears are rising:
Over the past two weeks, oil prices have responded to the crisis in Ukraine by spiking to a 14-year high resulting in gasoline prices surging to $4.25 per gallon as of March 9, 2022. Almost immediately, Wall Street economists began lifting their probabilities for a recession to occur in the United States within the next two years. Recently, Ed Hyman, one of Wall Street’s top economists, noted that gasoline prices are signaling a recession, but he believes gasoline prices are only part of the picture. We agree that they are only part of the picture. One of the indicators we watch for signs of a potential recession is the US Treasury Yield Curve, specifically the 3M/10yr curve. Investors worry the yield curve is going to invert (meaning short term yields are greater than long term yields) as inflationary conditions worsen. Many believe this typically signals a recession. While the curve has narrowed in recent weeks, it remains positive.
As inflationary fears increase, the Federal Reserve is slated to enact the first of their policy change actions this week. We believe Federal Reserve officials will raise the Fed funds rate by 25 bps (bps = 1/100th of 1%) at the March 16th meeting. Consensus expectations vary as to the speed and levels of future rate increases as the Fed seeks to dampen inflation without stalling out the growth engine driving the US economy. We believe there will be at least five rate hikes this year with a pause at one or two of the seven meetings remaining in 2022.
A look in the rear-view mirror serves as a reminder that the US. economy is still growing. With worries about slowing growth ahead, we believe it is important to examine the fundamentals underpinning the US economy:
- The unemployment rate is back to pre-pandemic levels: The most recent report from the Bureau of Labor Statistics showed an acceleration of job growth with the unemployment rate falling to 3.8%, which is only slightly higher than the 3.5% unemployment rate in February 2020, just before the shutdown from the pandemic.
- Corporate profit margins remain above average, and earnings are still growing. Current FactSet estimates are for profit margins for S&P 500 companies to be around 12% for the first quarter of 2022, which is above the five-year average. Further, data from the Department of Commerce shows that profit margins are at their strongest level in decades which speaks to the pricing power of large corporations to help offset the inflationary pressures they have already experienced. Corporate earnings trends remain positive for 2022 as well. Current consensus growth expectations are for year-over-year growth in the 8%-10% range.
- Purchasing Managers Indexes (PMIs) remain above 50 which bodes well for growth. The most recent ISM manufacturing index came in at 58.6%, revealing a higher-than-expected increase in US manufacturing activity during February. This was encouraging in light of the lingering impacts from supply chain disruptions. The ISM services component also remains above 50, with the most recent reading coming in at 56.5%.
- Consumer spending is holding up well despite inflation worries. In January, retail sales rose 3.8% month to month, which was the strongest increase since March of 2021 and raised overall retail sales to the highest level since the government started tracking the data in the early 1990s. Additionally, a recent Bank of America report noted strong trends in a number of categories including travel, restaurants, and public transportation suggesting consumers are resuming more in-person activities as COVID-19 fears subside.
We believe oil prices will be the determinant of future growth trends. The US economy has remained resilient despite the inflationary pressures created by COVID-19-induced supply chain disruptions. As strong as the data is, we know the look ahead is increasingly worrisome. Headline inflation, as measured by the Consumer Price Index (CPI), rose 7.9% year-over-year in February. Energy costs were the primary driver for the surge as gasoline prices rose over 6% in a one-month period. The conflict in Ukraine ensures the March CPI report will move even higher. For consumers, higher prices at the pumps could impact spending in areas considered discretionary such as eating out or travel.
It is also important to remember that higher oil prices impact more than just gasoline and heating oil. The average barrel of oil can also make everything from crayons and candles to asphalt. Businesses are also negatively impacted by higher energy costs and could alter hiring or expansion plans to offset them. We believe it will be critical to monitor consumer spending and business sentiment trends in the months ahead for changes in patterns. While consumer spending trends have been robust to date, the preliminary University of Michigan Consumer Sentiment data released last week was the lowest reading in over ten years. This suggests to us that energy prices are already having an impact.
Additionally, business sentiment is turning more pessimistic as evidenced by the most recent data from the National Federation of Independent Businesses (NFIB). In February, the NFIB Small Business Optimism Index fell to one of the lowest levels in five years, as labor shortages and supply chain issues continued to hamper business conditions. Further, 26% of small business owners pointed to inflation as the single biggest problem they faced in operating their business. This was the highest reading since 1981 for that metric.
Risk Management in Motion: Navigating markets requires focus and discipline, especially now when headlines and datapoints are sending mixed signals. Our Risk Management processes provide the road map for our way forward. We have systematically lowered the risk profile of all of our strategies over the past few months by lowering exposures to international equities and increasing cash levels in our balanced strategies. Our base case is still that the US does not go into a recession in the next 9-12 months, but we believe the risks of recession have clearly risen. Our view remains that markets can move higher by year end, but we are realistic enough to understand that changing conditions could warrant a change in our views and further adjustments to our positioning.