Oil Shock Could Trigger Correction, Bond Sell-Off, HFI Says
Stocks look primed for a 1970s-style decline that could leave investors with little room to hide, HFI Research warns.
The energy research firm said it’s bracing for more pain in financial markets amid as the oil shock doesn’t appear to be waning. The US-Iran war has sparked the greatest crude supply disruption in history, but stocks are “priced to perfection,” the firm said, with the major indexes hovering close to record highs.
Jon Costello, a lead analyst at the firm, pointed to the relatively muted reaction in equities and oil despite the massive hit to crude supply. Brent crude, the international benchmark, slipped 2% to around $95 a barrel on Thursday as traders continued to await a peace deal with Iran.
Much of the rally has been fueled by hope that a peace deal is just around the corner, though that optimism looks misplaced, HFI suggested. Even if the US and Iran were to come to an agreement immediately, supply is likely to remain disrupted for months, the firm said, pointing to higher shipping insurance costs and an estimate from the energy group ADNOC that it would take at least four months to restore around 80% of the lost oil supply.
Global oil reserves, meanwhile, are dwindling as countries rush to fill the supply gap. The US’s Strategic Petroleum Reserve fell to 357 million barrels last week, the lowest level in about two years, per the latest update from the Energy Information Administration.
The situation resembles that of the oil shock in 1973, HFI added, the year that an oil crisis sparked a 48% peak-to-trough decline in the S&P 500, Costello said. The index didn’t recover those losses for about seven years.
“Sustained high oil prices act as a tax on a slowing economy, and sudden price spikes become more likely, pressuring both the economy and stock prices. The market has priced in none of this, which leaves it dangerously exposed to a severe decline,” Costello wrote in a client note on Wednesday.
Bond turmoil
The bond market wouldn’t offer a shelter from an oil-driven sell-off, HFI said. The firm pointed to rising concerns about inflation, which have pushed yields higher in recent weeks. The idea has been that higher oil prices could stoke inflation in other areas of the economy, which could raise rates in the long-run and dent appetite for US Treasurys.
The 10-year US Treasury yield has cooled from its wartime peak, but remains close to 4.5%, a key psychological threshold that suggests investors are anxious about the underlying economic picture.
Inflation, meanwhile is still rising. Consumer prices accelerated 3.8% year-over-year in April, the fastest pace of growth in about three years, according to the Bureau of Labor Statistics.
Should higher prices spark a recession and a stock decline, that could also hit US tax revenues, amplifying concerns about the fiscal deficit and pushing yields higher, Costello speculated. He pointed to how bonds endured a long-running decline after the stock sell-off in the 70s, with the 10-year US Treasury peaking at about 16% in the early 80s.
“Bonds Are No Safe Haven in a Supply Shock,” Costello wrote. “Investors who held bonds hoping for a counterweight to equities instead suffered losses,” he added of the historical precedent.
Costello said he doesn’t expect the market to be hit as hard as it was in the 70s, due to the economy being less reliant on oil, though the market decline in ’73 was “instructive” of what could come next.
“If oil stays high, this is akin to a 1973 setup,” he said, adding that he preferred to hold cash and own high-quality names and short-duration investments in his portfolio. “For a decade, every oil shock was a buy. This is the one that isn’t.”
