Markets and consumers are likely to adopt a ‘we’ve seen it all before’ stance, with three reasons to remain optimistic that growth won’t be badly curtailed, says Strategist Peter van der Welle.
“The oil market was already tight prior to Russia’s invasion of Ukraine on 22 February,” he says. “With oil prices now exceeding USD 110 per barrel, reminiscences with previous oil shocks are strong. Oil prices even reached USD 140 per barrel before the Great Financial Crisis of 2008.”
“With the supply side relatively inelastic in the short term – especially in this era of transition towards a greener economy – it now seems that demand destruction should do the balancing act to lower prices. The possibility of forthcoming demand destruction has already started a growth scare.”
“Concerns are increasing that this oil price spike could usher in a near-term recession. Though higher real oil prices do directionally increase recession risks, there are several reasons to remain more sanguine on near-term recession risks stemming from a potential further rise in oil prices.”
Reasons to be sanguine
Van der Welle says a combination of declining global reliance on oil, the higher household wealth that was built up as spending was curtailed by Covid-19, and the correlation that oil price inflation has with the wider economy mean a serious slowdown is unlikely.
“The first point to make is that the energy intensity of oil production has been declining for decades, as well as energy usage as a percentage of GDP,” he says. “So, over time the susceptibility of the global economy to an oil shock has been declining.”
Energy intensity measured as a proportion of GDP has been falling for decades. Source: Refinitiv, Datastream
“Second, besides the susceptibility to a shock, resilience to any such shock also needs to be factored into the equation. Looking at cyclical energy consumption as a percentage of disposable household income in the US, one observes that currently there is little aggregate demand destruction taking place, indicating that households are able to absorb high oil prices for now.”
US leverage is low
“Oil prices seem to peak only at ‘peak rationing’: the point in the cycle when consumers have been forced to reduce their energy-related expenditures because high prices have started to bite. Currently, energy-related expenditures are slightly above their long-term trend.”
“Households therefore seem to have some wiggle room to weather even higher oil prices given that US household leverage dropped by 40% over the last decade while the ability to service household debt is high.”
“This allows for a larger share of their household income going towards energy spending that would otherwise have gone to debt and interest payments. Currently only 9% of household income goes to interest payments against a cyclical peak typically around 14%. This could leave US households a bit less sensitive to higher oil prices compared to historical averages.”
Relationship with GDP
Then there is the issue how higher oil prices initially correlate positively (and not negatively) with the real economy, Van der Welle says.
“Looking at the relationship between year-on-year oil prices and growth shows that GDP initially responds positively to higher oil prices for up to nine months, only to reverse its impact on a 9- to 24-month horizon,” he says. “As always in economics there are long and variable lags, and there is no difference this time.”
And one classic signal for an upcoming recession – the inversion of US yield curves – remains absent. Yield curve inversion occurs when it becomes cheaper to buy longer-dated bonds (such as 10 years) than shorted-dated debt (such as two years). It is a phenomenon that has signaled most recessions since WW2.
Waiting for the signal
“Real oil prices are still hovering around their long-term trend,” Van der Welle says. “It is true that a meaningful overshoot above this long trend in real oil prices from current levels would become worrisome and raises recession risk. However, for this to happen, one other signal needs to flash and that is an inversion in the US yield curve, which has not happened yet.”
“When the Iraq-Kuwait war caused an oil price spike in the early 1990s, this was preceded by a US yield curve inversion in 1989. The absence of 2-year/10-year inversion of the US yield curve is a crucial difference this time.”
“The surge in oil prices as we observe today directionally raises recession risk, but the lead-lag relationship could this time be more benign, and prolong the global economic expansion beyond what one would typically expect. History often only vaguely rhymes.”