Investment Strategy

Are consumers in for a long, hot and expensive summer?

Jun 10, 2022

U.S. gas prices are at all-time highs—with no ceiling in sight.

Stephen Jury, Global Commodity Strategist

Federico Cuevas, Global Investment Strategist

 

Our Top Market Takeaways for June 10, 2022

Market update

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.

This chart shows the contributions to Core CPI MoM for May 31, 2022: Core:* 63.14 Owners Equivalent Rent: 18.30 Airlines: 10.57 Used Vehicles: 9.36 Rent: 5.88 New Vehicles: 4.95 Medical Care Services: 3.79 Apparel: 2.12 Motor Vehicle Insurance: 1.68 Lodging Away from Home: 1.16 Other Goods: 2.33 Other Services: 3.33

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 tick 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 (seeing positive rates 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.

Spotlight

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.

This chart shows the global oil demand in millions of barrels per day in 2020, 2021 and forecasted for 2022. In 2020, it began at 100, fell to 79 in April, rose to 95 in December. In 2021, it began at 93, rose to 99 in June and 102 in December. In 2022, it was forecasted to start at 98, fall to 97 in April, rise to 102 in August and slightly fall to 102 in December.

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.

This graph shows the U.S. operating crude oil distillation capacity in millions of barrels per day from 1990 to 2022. It began at 180, rose to 203 by 2004 and 222 by 2018. By 2022, it fell to 208.

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.

This chart shows the daily national average of gasoline prices, in $/gallon, from 2004 to 2022. It began at $1.7 and rose to $4.1 by July 2008. It plummeted to $1.6 by December of that year. It rallied to $4.0 and remained relatively flat. It then dropped to $2.0 in January 2015 and rose slightly. It dipped to $1.8 in April 2020 before rising to a series high of close to $5.0 in June 2022.

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.

Investment implications
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.

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Our Top Market Takeaways for June 10, 2022.

All market and economic data as of June 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

 

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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