Energy prices are likely to rise this winter, despite the downward trend in the broader market. As inflation looks likely to persist, the oil and gas exploration and production industry — which has shown sensitivity to inflation — may help bolster equity portfolios.
Both equities and fixed income resumed their downward trend last week, as hotter-than-expected Consumer Price Index (CPI) inflation sent 10- and 2-year Treasury yields to highs not seen in more than a decade.1 The yield curve remains inverted as the 10- and 2-year yield spread has been negative for more than 70 days now.2 This inversion is the longest since the Global Financial Crisis.
Housing Market Slows
Mortgage rates now stand at multi-decade highs. The National Association of Home Builders (NAHB) Housing Market Index and other housing sector data are likely to show further slowdown in the housing market.
Q3 Earnings Season Begins
Big banks kicked off the Q3 earnings season. So far, they are generally reporting lower profits, higher net interest margins, and significant declines in investment banking fees.
Watching Inflation Around the Globe
Eurozone and UK inflation will likely continue trending higher in September. In the UK, Prime Minister Liz Truss reversed more of her government’s tax-cut plan, after already suspending an initiative to cut the top rate of income tax. Truss also fired Treasury chief Kwasi Kwarteng to shore up support in her party.3
China’s 20th Communist Party Congress opened on October 16, 2022. Investors will likely pay close attention, looking for signs of changing COVID policy and key senior leadership changes. Both could impact the growth outlook of the second largest economy.
US CPI Inflation was higher than expected for September, as core CPI inflation reached a new high.4 The news raised market expectations for a steeper rate hike at the November Federal Open Market Committee (FOMC) meeting.
The University of Michigan’s Consumer Sentiment Index improved in October, reaching a six-month high.5 Yet inflation expectations for the year ahead rose for the first time since March. Perhaps unsurprisingly, September US retail sales were little changed from August as, amid high inflation, consumers pulled back spending on big purchases.6
Preparing for Winter Energy Prices
The energy sector’s earnings outlook and sentiment remain strong as analysts further upgrade the sector’s earnings growth estimates to 146% for this year7 — despite recession concerns and the fact that weak Chinese demand has weighed on oil prices.
Energy prices are likely to rise this winter, boosted by OPEC Plus’ larger-than-expected production cut, multi-year-low inventories, and continued global supply disruption. This may help support oil and gas explorers’ and producers’ profitability amid an earnings slowdown in the broader market.
US Crude Oil and Petroleum Products Inventory at Five-Year Low
Implementation Idea: SPDR® S&P® Oil & Gas Exploration & Production ETF (XOP)
September’s stronger-than-expected CPI inflation data underscored the persistence of inflationary pressures. The oil and gas exploration and production industry has shown the greatest sensitivity to year-over-year CPI inflation among 21 S&P Select industries,8 making it a potentially powerful tool to defend equity portfolios in an elevated inflation environment.
In addition, with one of the lowest correlations to the broad market since inflation began surging last year,9 the industry could potentially provide diversification benefits and resilience to a core equity portfolio. And despite recent strong performance, valuations for the oil and gas exploration and production industry remain attractive, trading near a 70% discount to the S&P 500® Index based on forward P/E ratio.10
1 Bloomberg Finance, L.P., as of October 14, 2022. 2 Bloomberg Finance, L.P., as of October 14, 2022. 3 Reuters, “UK’s Truss sacrifices finance minister, scraps tax plan in fight to survive,” October 14, 2022. 4 US Bureau of Labor Statistics, as of October 14, 2022. 5 University of Michigan, Consumer Sentiment, as of October 14, 2022. 6 The US Census Bureau, as of October 14, 2022. 7 FactSet, as of October 13, 2022. Estimates are based on consensus analyst estimates compiled by FactSet. There is no guarantee that the estimates will be achieved. 8 FactSet, as of August 31, 2022. Based on 3-year beta to US headline and core CPI. The universe is S&P Select Industry indices. 9 Correlation is calculated for the period from January 1, 2021 to August 31, 2022, based on weekly returns of the S&P Select Industry indices and the S&P 500 Index. 10 FactSet, as of October 12, 2022. 11 Bloomberg Finance, L.P., Morningstar, as of October 13, 2022. Morningstar category: Equity Energy.
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