Week in Review
One of the four takeaways in our 2018 Outlook was, “It’s the Economy,” meaning that over the long term, financial markets tend to do a good job shrugging off headline risk and political drama. Instead, markets focus on the health of the economy. This attribute was once again demonstrated this week with equity markets gaining more than 2 percent despite heightened geopolitical tension as the U.S. formally exited the 2015 Iran nuclear deal. On the economic front, it was the return of “goldilocks” with small business and consumer confidence both exceeding expectations and remaining near cycle highs while at the same time inflation and wage growth were weaker-than-forecasted. This is a bullish combination for U.S. equities because economic confidence is high while a lack of inflationary pressure should direct the Fed to increase rates at a slow and measured pace. Yields were flat on the week as an initial burst due to increasing oil prices was tempered by the aforementioned inflation data released on Thursday.
Over the past several weeks, energy stocks have enjoyed a nice lift after lagging meaningfully in the first quarter. While the price of oil has been strong, oil stocks haven't been moving as high as they should have. As the market saw oil demand remaining strong and questions about supply lingered, specifically coming out of Venezuela, energy stocks have finally started to participate. Also this week, oil received another boost as the U.S. pulled out of the Iran nuclear deal, which will result in sanctions and potentially limit oil exports from Iran. This prompted West Texas Intermediate (WTI) crude oil to rally above $70─the first time since 2014.
Clients have inquired about when these developments will impact gas prices and become a headwind for the economy. While gas prices are correlated to oil prices, it isn’t a one-to-one relationship. Gas demand is fairly inelastic. The chart below from the International Energy Agency (IEA) shows the average U.S. retail gas price since the mid-1990s. Amazingly, our current prices are still meaningfully lower than the $4.00 levels experienced multiple times over the last 10 years.
Source: International Energy Agency
During the past decade, there was not meaningful reduction in gasoline demand until prices reached the $4.00 range. Even the 50-percent-price increase seen over the last two years has not affected consumer behavior. Ford Motors’ recent decision to stop building all sedans and hatchbacks in order to focus on SUVs and trucks reinforces that consumers are more-than-happy to spend a little more to fill up their larger tanks. It also doesn’t hurt that the average U.S. vehicle is getting four-to-six more miles-per-gallon than seen 10 years ago.
If consumers are spending more on gas, money must come from other places. Fortunately, the U.S. economy can support these higher prices. With unemployment at historic lows of 3.9 percent, the U.S. consumer has enjoyed an improvement in their take-home pay due to the Tax Cuts and Jobs Act. At current gas prices, Morgan Stanley estimates that consumers will spend an additional $38 billion filling up their vehicles in 2018 compared to 2017. To put in perspective, that is only one-third of the benefit that workers will have experienced from recent tax cuts. For gas prices offset tax cuts, gas prices would have to increase by another 70-to-80 cents.
Takeaways for the Week
- Energy stocks are finally tracking gains in the underlying commodity
- While gas prices could impact consumers’ cash flow, we don’t anticipate any behavioral changes that would adversely impact the economy in the near term