Oil price spikes – what does it mean for inflation and the stock market?

The oil price has crept higher over the summer months. Back in June, you could pick up a barrel of brent crude oil for less than $75, now it’s trading above $95 – 26% higher since July.

This is a big move. When the price of a commodity like oil rises sharply it can have a big impact, including on consumer and business behaviours.

US inflation also exceeded forecasts in August, and more than half of this jump was driven by gasoline prices. Rising oil prices are already impacting the real economy.

Here’s a closer look at how the world can manage with oil above $95, and what this dynamic could mean for investors.

This article isn’t personal advice. If you’re not sure whether a course of action is right for you, ask for financial advice. All investments and any income they produce can fall as well as rise in value, so you could get back less than you invest. Past performance isn’t a guide to the future.

Kathleen Brooks is Founder of Minerva Analysis, a market analysis company. Hargreaves Lansdown may not share the views of the author.

Why we’re not going back to the 1970s

When oil prices rise it inevitably draws comparisons to the 1970s. The oil price shock in the 1970s caused persistent high inflation, unemployment, and stagnant growth, known as stagflation.

However, there’s a good argument to be made that we’re not going back to the 1970s, and that the global economy is more resilient to oil price shocks than ever before.

Recent analysis from the International Monetary Fund (IMF) shows that the world relies less on oil than it did back then.

The IMF works this out by tracking the number of barrels of oil needed to create $1 million of GDP and comparing today’s number with the 70s. It found that oil intensity in the 1970s was 3.5 times higher than it is today. Not only did the world require more oil to generate output in the 1970s, but between August 1973 and January 1974, the oil price tripled.

The global economy has become less reliant on oil to generate GDP. However, other factors are also important to help build the global economy’s resilience to an oil price spike. For example, there’s a lower prevalence of wage-setting mechanisms that adjust worker pay based on inflation.

So, even the oil price rising by 26% in a few weeks might not trigger a broad inflationary effect throughout the economy. For example, in the US, headline prices rose from 3.2% to 3.7% in August, but, core inflation, which strips out energy and food prices, fell to 4.3% from 4.7%.

Inflation – headline versus core

If rising oil prices, which are included in the headline measure of inflation, don’t impact core inflation rates, does this mean that rising oil prices don’t necessarily impact monetary policy?

The answer is more than a straight yes or no.

For example, the Eurozone Central Bank and the Bank of England both formally target the headline consumer price index (CPI). However, the Federal Reserve (Fed) focuses on inflation that’s derived from the personal consumption expenditures index, excluding food and energy – the core PCE.

Former St. Louis Fed President James Bullard wrote in 2011 that the focus on core PCE in the US is because “historically, the food and energy components were highly variable… and their large price fluctuations were usually expected to correct themselves within a relatively short period of time.” Hence, even the recent spike in oil prices hasn’t moved the dial for US interest rates.

The prospect of a further 25 basis point rate increase in interest rates from the Fed by the end of this year, has a 39% probability – a month ago this was 32%.

The prospect of a 50 basis point rate increase in interest rates between now and the end of the year is still only 5%.

This shows us that the market doesn’t see the recent oil price surge as having a huge impact on interest rates in the US. Interestingly, the market also doesn’t see the recent oil price rise as having a big impact on UK or Eurozone interest rates over the next 12 months.

Here’s what the current market-based interest rate expectations look like for the UK.

UK implied interest rate expectations

Source: Bloomberg, as of 14/09/2023.

Do oil prices affect stock market returns?

As an investor, this is an important question when it comes to rapidly rising oil prices.

It might seem logical to assume there’s a direct relationship between oil prices and stock market behaviour. But, a hike in the oil price doesn’t necessarily mean the stock market will be weak.

Analysis from the Federal Reserve back in 2008 found that the relationship between the price of oil and the S&P 500 isn’t particularly strong.

You might think rising oil prices can hurt corporate profits and consumer sentiment due to higher input costs for businesses and households. However, the Fed analysis didn’t find evidence of a negative correlation to prove that when oil prices rise, stocks fall.

This analysis looked at different time periods and also analysed stocks and oil when oil was at its peak and when the oil price bottomed out. But it still didn’t find a statistically significant relationship between the two asset classes.

There was some variation between sectors within the S&P 500. Unsurprisingly, the Dow Jones Transportation Index had the strongest statistical correlation with the oil price, which suggests that transport companies are impacted by fluctuations in the price of oil.

More recent analysis from 2016, conducted by the former President of the Federal Reserve, Ben Bernanke for the Brookings Institute, found that the price of oil is mildly positively correlated with stock market returns.

However, Bernanke’s analysis broke down the changes in the oil price into the part associated with demand, and the part of the oil price that is driven by supply factors.

The correlation between stocks and the demand-related changes in the oil price is higher than the correlation between stocks and the supply-related changes to the oil price. As Bernanke notes, that could be because when stock traders react to changes in the oil price, they do it “because fluctuations in oil prices serve as indicators of underlying global demand.”

Another reason why stocks and oil might tend to move together, could be down to market conditions. For example, traders move away from stocks and commodities like oil when there’s a volatility shock.

Likewise, when the oil price falls, it can drag stock markets lower because it can damage the creditworthiness of oil producing companies and countries.

More recent analysis from 2021 found that the relationship between oil and stock market returns in Japan had been disturbed by COVID-19. It found that the predictive effect of the oil price on stock market returns had weakened dramatically since the pandemic, even if the relationship between stocks and oil remains positive.

How long will the oil price stay high?

Oil might have surged in recent weeks, however, there are lots of challenges when it comes to trying to predict the oil price. For example, world oil demand is on track to grow by 2.2m barrels per day in 2023.

Because of the output cuts from Saudi Arabia and Russia, the oil market will also lock in a substantial market deficit through to the fourth quarter of 2023.

Demand is also increasing with China accounting for 75% of the increase in world oil demand in 2023. This is supporting the oil price for now.

However, the picture’s expected to shift dramatically from 2024. Demand growth is expected to slow to around one million barrels a day. That’s because of things like the global economic recovery running out of steam, energy efficiency gains, electric vehicles becoming more popular and working from home further suppressing demand.

Demand for oil is expected to peak by the end of 2028, which could have severe ramifications for the oil price, and for oil producers’ revenues in the medium term.

The global economy’s reliance on oil is expected to fall further in the future. But in the short term, when oil is trading above $95 per barrel, it’s worth remembering two things.

Firstly, it’s not expected to stay at this elevated level for the long term. And secondly, the relationship between oil and stocks isn’t clear cut. It’s always worth watching fluctuations in commodity prices, but they might not directly impact your portfolio as much as you might think.

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