Markets wrestle with a commodity price shock – Our take on its impact

Geopolitical turmoil threatens commodity supply – U.S. stocks started the week logging their worst daily decline on Monday (3/7/2022) since October 2020 amid the threat of further sanctions on Russia's exports. With the larger energy and materials sector weights in the TSX, Canadian equities held up better. Russia is a key supplier of oil, natural gas, metals and agricultural commodities. As the U.S. and European allies consider banning oil and other imports, and Russia also threatens to retaliate by cutting off gas supplies to the EU, the risk of supply disruptions has risen, and prices have rallied. This recent increase ranks among many other historic moves, as oil prices briefly spiked to $130 per barrel (highest since 2008), and gas prices, wheat, aluminum, nickel and European natural gas all hit record highs¹.

Canada is more insulated from the recent price shock as oil and gas are significant contributors to the domestic economy. Still, the Canadian economy and markets will be heavily influenced by what's playing out in the world and the U.S. In the past, major commodity-price shocks have been a catalyst for, or helped accelerate, US. recessions, particularly when other fundamental factors have made the economy vulnerable to shocks (e.g., in 1980, 1990, 2000, 2008). However, recession is not an inevitability, as the years 1996, 2005 and 2011 showcase. We think that caution is warranted, but we see reasons to believe that 2022 can join the latter group.

^{Source: FactSet. Past performance does not guarantee future results. Market indexes are unmanaged and cannot be invested into directly.}

The chart shows the recent rise in the Bloomberg commodity index and the start of U.S. recessions.

Solid fundamentals provide a cushion – While the situation is fluid and the range of outcomes wide, we believe that positive economic momentum along with structural changes in the U.S. economy over the past decade can act as a buffer against an energy-price shock. A comparison of current conditions vs. the ones that prevailed in the three years between 2011 and 2013, which was the most recent prolonged period of elevated oil and gas prices, illustrates well the point that some cushion exists before a major decline in consumer demand takes place. While oil, gasoline and a broad index of commodities are trading at prices similar to then, U.S. consumers' disposable income is nearly 50% higher today. With the economy still managing to chug along back then, we think it should be able to do so this time as well, especially when considering the following:

• U.S. unemployment is near record lows and job openings at record highs, pointing to strength in the labor market that is unlikely to fizzle soon.
• Household debt relative to income is low and savings are high, suggesting that consumers are in a better financial position to weather high energy bills.
• The share of energy spending remains on a long-term downtrend because of efficiency gains, fewer miles driven, and urbanization trends.
• Because of the shale revolution, the U.S. has become a net exporter of oil from a net importer. Higher oil prices and production can positively contribute to economic growth, acting as a partial offset to lower consumer spending, making the economy more resilient to an oil-price shock.

Similar prices but improved fundamentals

The table compares current commodity prices and economic conditions with the ones that prevailed in the period 2011-2013.

Slower growth and higher inflation ahead – The scale of sanctions, along with the resulting impact on commodity prices and the economy, remains unknown. However, if the spike in prices persists and/or accelerates, we expect downside surprises to growth and upside surprises to inflation. High energy prices act as a tax on the consumer, reducing purchasing power and, consequently, consumption. With consumer spending accounting for almost 70% of the U.S. economy and 60% of the Canadian economy, growth will likely slow. Yet the slowdown is likely to happen at a time when the economy is in a position of strength.

Before the Ukraine/Russia crisis, U.S. and Canadian GDP were expected to grow about 3.6% this year vs. the 2% average pace over the past decade. Even when assuming a sizable slowdown equal to the average shock in past major oil spikes when the U.S. economy was more reliant on oil, we think that GDP growth can flatline but stay positive. We estimate that it would take a sustained move of over $150 a barrel to result in a meaningful decline in consumer demand.

On the inflation front, renewed concerns about supply-chain disruptions suggest that the long-awaited peak in price increases for goods is being pushed further out. Aside from the straightforward impact of higher energy and food prices, supply concerns of certain commodities, like palladium, which is used for catalytic converters in cars, threaten to exacerbate current bottlenecks. Because of high inflation, central banks are not in a position to ease policy like in past periods of economic slowdown. The silver lining could potentially be that as growth slows central banks might hike interest rates less aggressively than what the bond market currently expects.

^{Source: FactSet, Edward Jones.}

The graph shows the share of energy spending in total household consumption which has been in a long-term downtrend.

Action for investors

• The probability of a negative shock to the economy has risen over the past two weeks. However, we think that recession concerns are likely premature, as significant offsets can counter the headwinds from surging commodity prices. We recommend using this period of volatility to rebalance, enhance diversification and add quality investments at improved valuations.
• European equities are likely to be the most negatively impacted based on the region's reliance on Russian energy, while domestic equities could prove more resilient. During this period of uncertainty, Canadian equities and bonds may offer relatively better performance. Within the context of a diversified portfolio, we continue to recommend an appropriate exposure to emerging market and overseas developed large-cap equities.
• While geopolitical risks persist, defensive sectors like utilities, consumer staples and health care are likely to hold up better after underperforming last year. Aside from energy, which directly benefits from rising oil prices, appropriate exposure to cyclical sectors, like industrials, is still warranted, as we continue to think that cyclical optimism will eventually return if tensions de-escalate.

Angelo Kourkafas, CFA
Investment Strategist

^{Source: 1. Bloomberg}