Are consumers in for a long, hot and expensive summer?
U.S. retail gas prices are at all-time highs – with no ceiling in sight.
Our Top Market Takeaways for June 10, 2022
It’s lonely at the top
The U.S. CPI report came in hot with another four-decade-high print of 8.6% at the headline level—above expectations. In fact, the pace accelerated +1% relative to last month, increasing risks of a recession, as the Federal Reserve may have to take greater measures to tackle inflation. Food and energy prices continue to be the significant drivers, hugely impacted by restricted supply. Meanwhile, cost increases in the core bucket (which excludes food and energy) also came in above expectations. There’s no denying inflation is broad-based, but several outliers continue to see price increases at an even more exceptional rate. This month, the prime culprits were rampant increases in airline and auto prices. Markets were quick to digest the news, with stocks reacting with a selloff and the yield curve flattening via a sharper increase in rates for shorter-dated Treasuries versus longer-dated ones.
We would be remiss not to mention a few other notable developments this week:
- As more companies make headlines for announcing hiring freezes, we saw U.S. initial jobless claims ticked to their highest level since January.
- The ECB has entered the global central bank tightening arena. At their meeting this week, policymakers confirmed they’ll end asset purchases this month, hike policy rates for the first time in July and exit negative rate territory in September (for the first time since 2012!).
- China’s reopening process is seeing fits and starts. Despite recent easing of virus containment measures, Shanghai and Beijing announced incremental testing mandates and restrictions.
As investors continue to digest the evolution of risks, oil prices have moved even higher and look set to head into the weekend over $120 per barrel. The 10-year Treasury yield has risen above 3.1%, and the 2-year Treasury yield is creeping up toward 3.0%. And in equities, even before today’s CPI print, the S&P 500 saw its largest one-day dip in two weeks on Thursday. That left the index down -2.2% on the week heading into Friday. Yet again, the energy sector is the lone positive performer.
Year-to-date, energy stocks have jumped more than +60%, while the rest of the market has moved lower. Investors with energy exposure might react to that with relief, but that contrasts against how higher energy prices are making consumers feel. Prices have been rising across the economy, and many are feeling a particularly acute pinch at the pump. With that said, today we unpack the drivers and implications of higher gas prices as summer heats up.
Are we there yet?
As global petrol and gasoline prices continue to rise, the volume of client questions is increasing. How much higher can they go? Why are they moving so quickly? What does this mean for the consumer? Let’s begin by examining why this is happening in the first place.
Start with the move in raw energy prices.
When you restrict the existing or future supply of fossil fuel energy through ESG capital restrictions or government policy, the price of that energy will increase, unless demand drops in perfect symmetry or alternatives become available at scale.
In the next step, global refiners take an energy input such as crude oil, which is now higher in price, and then access a feedstock (input used to come up with a finished product), usually natural gas—which is now also higher in price—which the refiner needs to burn to refine the crude oil. In the refining process, the refiner typically creates two barrels of gasoline and one barrel of distillate fuel (diesel, jet fuel or heating oil) from three barrels of crude. This is known as the 3-2-1 crack spread.
In the final step, the refiner sells the refined products to the highest global bidder. The buyer may be in the United States, Latin America, Asia or Europe.
A quick note: U.S. refinery capacity has actually declined in recent years and is currently running at full capacity. No new refinery has been built in the United States since 1977, and global capacity is very slowly increasing. War in Eastern Europe has taken many Russian refineries offline, and European refineries have cut back on refining diesel because of high natural gas prices. And per the above, we know there is less product available, but higher demand. The price of the product obviously will now increase, along with the refiners’ profits.
This in turn leads to higher gasoline (petrol) prices at the retail pump.
What does this mean? And can the consumer keep up?
Gas prices are up over 50% in the United States over the past year, and a whopping 88% in Europe. At some point, this has to impact the consumer.
In the short term, prices could go even higher. With the global refineries struggling to deliver, local governments are trying to help by cutting gasoline taxes: In the United States, eight states have taken action. We think this will support more demand, and summer in the United States typically means more people driving and flying. The American Automobile Association estimates 8.3% more people travelled over the Memorial Day weekend. Gasoline inventory stocks on the U.S. East Coast are at their lowest point in eight years.
That all said, prices could keep climbing until they get so high that consumers aren’t willing to pay up—eroding demand.
We aren’t there yet, but we are getting closer. There is still some room for gas prices to move higher until the consumer will start to react in a more meaningful way. We continue to believe excess savings on hand—especially for the higher-wealth demographic—can act as a cushion against these persistent price increases. But our Investment Bank estimates that if gasoline prices break above $6 (currently $4.90) in the United States this summer, demand for gasoline in August will drop by at least 7% and possibly more.
What it means for investors
It’s already been a painful ride so far, but things could get worse. With no good short-term solutions available, prices should continue to rise until consumers pull back. It could be a long, hot and expensive summer. On that note, holding a sliver of tactical exposure to the energy complex—through equities, bonds or the commodities themselves—may be prudent as a hedge.
Volatility in the broad stock market is all but sure to continue, but current energy sector valuations still look reasonable relative to oil price expectations and solid profit margins. Investors should maintain a risk-aware approach to pursuing exposure, but on a tactical basis, we think supply-demand imbalances coupled with soaring prices create opportunities in the space.
Talk to your J.P. Morgan team to learn more about how to position for the potential of persistently higher energy prices in your portfolio.