Vanguard analysis finds that oil price spikes don’t lead to lower stock returns; Federated and Barclays like Mexico; Morgan Stanley finds that ETFs are tracking their markets more accurately; Keefe, Bruyette & Woods report that demand for “life-cycle” type investment products should grow.

Joseph H. Davis, Roger Aliaga-Diaz, Vanguard Investment Counseling & Research

Oil, The Economy and the Stock Market

In the past, sharp rises in oil prices have coincided with bear equity markets, sparked higher inflation and government bond yields, and presaged economic recessions. Recently, as oil prices have leapt past $100 a barrel, some analysts warn of a prolonged period of “stagflation,” or persistent inflation coupled with high unemployment rates. Other analysts are more sanguine, arguing that demand-driven oil-price shocks are less relevant for modern economies that have become less energy-intensive.

This paper addresses several related questions. First, what impact does a given oil-price shock have on economic growth, and have those effects changed over time? How should monetary policy respond to oil-price shocks, now and in the future? How has the stock market—across countries and sectors—reacted to changes in oil prices? Does this response vary depending upon the direction or source of oil-price movements? Finally, do fundamentals explain the rapid rise in oil prices to more than $100 a barrel? We focus our analysis on the U.S. economy and financial markets, although our results are also applicable to the U.K. and broader European economies.

We find that the negative short-run impacts of oil-price shocks on U.S. economic growth since the early 1980s are similar to those in earlier decades. Indeed, oil-price shocks can still induce a U.S. recession, given the inherent lag between a change in monetary policy and its impact on real growth. However, the negative “second-round” real GDP effects of oil-price shocks witnessed during the 1970s have been notably absent over the past 25 years. Our empirical analysis attributes this phenomenon primarily to the more muted response of long-term inflation expectations and long-term interest rates to oil-price movements. This change enhances the present-day Federal Reserve Board’s flexibility in addressing oil-price shocks that, in the past, presented a difficult policy trade-off with respect to stagflation. Our simulations indicate that today it would be appropriate for the Federal Reserve to lower short-term interest rates in response to an oil-price shock, as long as long-term inflation expectations do not rise from their desired level. We provide rules-of-thumb for determining the proper change in the Federal funds rate for a given oil-price shock under alternative macroeconomic scenarios.

We find that global stock markets have responded fairly symmetrically and inversely to changes in oil prices since the 1970s, with a 10% increase in oil prices associated with a statistically significant 1.5% lower total return. However, when we decompose movements in oil prices, we find that the stock market’s reaction to oil-price increases varies dramatically, depending on the source of the oil-price shock. Specifically, the stock market—particularly in the U.S. industrials and materials sectors—responds quite favorably to oil-price increases attributed to global-demand shocks. A key implication of these stock regressions is that oil-price increases do not uniformly lead to lower stock returns. Interestingly, our oil-price decomposition suggests that the recent surge cannot be fully explained by oil-supply disruptions, global-demand fundamentals, or the decline in the value of the U.S. dollar. Do higher oil prices matter?

Throughout the 1990s, crude oil prices in the United States averaged roughly $20 a barrel, with highs of $35 a barrel set during the 1990–1991 Persian Gulf War and lows of approximately $11 a barrel reached after the 1998 emerging-market crises.2 Since that time, petroleum prices have skyrocketed to once unimaginable levels. In early 2008, oil prices topped $110 a barrel, breaking the inflation-adjusted highs established in April 1980. As oil spot prices have risen, so too has the futures market’s perception of oil’s long-run or “fair” value. In the past, dramatic oil-price increases have often been caused by oil-supply disruptions centered in the Middle East. Notable oil-supply shocks include the 1956 Suez Crisis, the 1973 Arab–Israel War, the beginning of the Iranian Revolution in 1978, the onset of the Iran–Iraq War in 1980, and the 1990 Persian Gulf War. Today, some analysts point out that the dramatic rise in oil prices from $20 a barrel in 2001 to more than $100 in 2008 is primarily the result of the world’s first global-demand shock.

Throughout this decade, the global economy has expanded robustly, and commodity demand has surged.  The emerging-market economies of China and India have more than doubled their combined share of world oil consumption since 1990, and have accounted for more than one-third of consumption growth since 2000.3 Many experts anticipate that China’s demand for oil will double again in the next two decades. In the past, sharp rises in oil prices have sparked higher inflation. More recently, as oil prices rapidly surpassed $100 a barrel, some analysts have warned of a prolonged period of U.S. stagflation, with the economy’s inflation and unemployment rates rising in tandem. Economists have long observed that oil-price shocks tend to precede U.S. recessions, as consumer discretionary spending declines and future investment plans are postponed.4 To demonstrate the powerful effect that oil-price shocks can have on the business cycle, we compare the year-over-year growth in actual U.S. real GDP with what it would have been under the counterfactual case of no oil price increases.