Energy Prices, Interest Rates and Volatility: Our Thoughts on a Rocky Tuesday

It’s baaaaaaaaaack. The volatility monster, that is. After months of calm, the S&P 500 has delivered more big daily moves of late, including more big negative ones. Last Monday brought a -1.7% drop as the world freaked over a Chinese property developer’s potential default.^[i] Today, it was a -2.0% fall as a mooted oil supply crunch and an uptick in 10-year US Treasury yields spooked many.^[ii] When markets were calmer, we reminded you that volatility would return and, when it did, we think the best thing to do is stay cool-headed, assess the situation carefully and think beyond the next week or month. That holds today, in our view.

With markets rocky again, we think this is a good time to reiterate some advice we gave at September’s outset: “While they are regular occurrences, substantial pullbacks draw reams of attention—and pundits’ explanations about why more trouble must lie in store. But letting this influence your portfolio decisions generally isn’t beneficial.” We are seeing this phenomenon everywhere now, making it critical to put your emotions to the side and assess their arguments carefully. If they are right and a lasting downturn lies ahead, there will likely be plenty of time to move strategically to avoid the worst of it. If they are wrong, then you will have saved yourself the financial setback (and heartache) of selling after a sharp drop, then missing the recovery.

So with that said, let us take on today’s central fears. The first: oil. Or more specifically, energy, as oil and natural gas prices are spiking in tandem. The central fear is not that high oil prices will hamper consumption, but that they represent severe shortages that will crunch global energy supply this winter—particularly if more countries start relying on oil-fired power plants to compensate for shortages at natural gas-fired plants and wind farms. Supposedly, we are already seeing the first signs of this with mile-long lines at gas stations in the UK and electricity rationing in China. Yet in our view, a closer look shows neither of these situations is representative or terribly forward-looking for global energy markets. In the UK, the shortage stems from panic-buying, akin to 2020’s great toilet paper freakout. But the root issue isn’t a shortage of gas itself, but a shortage of truck drivers to transport said gas to filling stations. When BP warned of temporary closures at some gas stations due to the lack of drivers, it triggered a classic run, making a nationwide shortage a self-fulfilling prophecy. While we won’t hazard a guess at when this acute problem will end, UK hauling companies—like their global counterparts—are already raising pay packages in an effort to entice new drivers, and there is some anecdotal evidence that this is starting to work. In time, like the world’s many other logistical bottlenecks, this should ease.

As for China, this is less about oil and more about a self-induced electrical shock tied to price controls and the country’s reliance on coal. Coal prices are up globally due to reopening and rising electricity demand, but they are spiking in China due to the country’s ban on Australian coal imports. Usually, utilities can pass higher prices to consumers, who respond to that signal and find ways to curb electricity use. But China caps retail electricity prices, forcing coal-fired power plants to operate at steep losses. As a result, many have closed for “maintenance” or begun operating well below capacity. The resulting blackouts have idled some factories and forced others to run on diesel-powered generators, which runs counter to the government’s emissions ambitions. Here, too, we will refrain from speculating over the endgame. But considering President Xi Jinping is up for “re-election” next year and seems intent on retaining power, the likelihood officials allow prolonged electricity shortages that might spark unrest seems exceedingly low.

Overall, we see a lot of pundits reading too much into breaking news and not paying enough heed to longer-term supply and demand considerations. On the supply side, US oil and gas output took a hit from Hurricane Ida, which temporarily idled refineries along the Gulf Coast, but that is easing. Meanwhile, shale producers are ramping back up, which should increase supply of both oil and natural gas, which is a byproduct of the hydraulic fracturing process. Gone are the days when companies had to flare off excess gas because supply dwarfed demand. Outside the US, OPEC nations have ample spare capacity and are already discussing production increases. So in our view, the evidence points to supply rising and balancing out demand, which should render severe winter shortages a false fear. (Note, too, that if the wind starts blowing in Europe, their wind power plants would also add to electricity supply, easing demand for natural gas.)

Rising long-term interest rates are also a false fear, in our view—another case of pundits reading too much into short-term wiggles. Ten-year US Treasury yields’ move thus far—from 1.17% on August 4 to 1.53% as we write—isn’t huge, and today’s rates are exceedingly low by historical standards.^[iii] Some pundits acknowledge this but warn the uptick is just the beginning of rates’ response to the Fed’s eventual tapering of its quantitative easing bond purchases. We think this is backward. If long rates were to rise as people expect, it would actually be a positive, as it would steepen the yield curve. We have well over a century’s worth of theory and data showing this is fuel for economic growth, as it gets more money into households’ and businesses’ hands to put to work. Loan growth has been anemic this year, which we blame on the rather flat yield curve—banks borrow at short rates and lend at long rates, and a slim gap between the two pinches profits and discourages broad lending. A steeper curve would widen banks’ net interest margins and incentivize them to pick up the pace. So while the world sees tapering as “tightening,” we see it as stealth stimulus.

At the same time, we don’t think long rates are likely to shoot radically higher and stay there. When the Fed last tapered QE, rates rose in 2013’s second half as taper talk swirled and markets priced in the program’s wind down—but they fell as the Fed actually tapered and eventually ended its bond purchases in 2014. Markets had pre-priced tapering, allowing other variables to have more influence on bond yields once the Fed acted. We see a high likelihood of that scenario repeating today, as yields’ rise since early August has coincided with escalating taper talk. The Fed has all but put its hand on its heart and sworn to start tapering this autumn. If markets are at all efficient, they have discounted tapering and will resume reflecting longer-term fundamentals. For long-term interest rates, the primary variable is inflation, which looks unlikely to remain elevated over the next 3 – 30 months. As we showed repeatedly over the summer, recent fast inflation rates stemmed from a handful of categories where reopening spurred hot demand and businesses couldn’t respond swiftly with supply increases. Those are now starting to cool off. That isn’t to dismiss the summer’s price increases, nor does it mean we are headed to zero inflation. But one-time jumps that slow to the pre-pandemic norms aren’t the same thing as inflation rising 5% year in, year out. Markets know this, even if hyperbolic headlines won’t admit it.

Sentiment-driven pullbacks can start at any time, for any or no reason. They can also end at any time, for any or no reason—this is why we think reacting to them is an error. If your emotions and instincts are making you think action is needed, we think it is best to stop, reflect and ask yourself: What if I am wrong?

While we don’t know when this bout will end, we do know some things about negativity in general. One, we know corrections—sentiment-driven drops of -10% to -20%—are normal in bull markets and don’t operate on schedule. This bull market hasn’t had an official correction yet. Perhaps we are enduring one now. Time will tell. Two, bear markets—longer, deeper declines of -20% or worse with an identifiable fundamental cause—start for two reasons. The first, and most common, is when investors become euphoric and develop outlandish expectations, setting themselves up for big disappointment. We don’t see that now, as sentiment has cooled considerably over the last six months. The second, which has featured in the last two bear markets, is when a giant, shocking negative wallops stocks before euphoria arrives. Last year’s lockdowns were a wallop, and so was the global financial crisis in 2007 – 2009. We assess risks and potential negatives daily, looking closely for things others miss. Right now, we see the opposite—overstated fears that everyone is looking at. That suggests this, too, shall pass.

So breathe deep and hold tight. Last year’s lockdown panic aside, bear markets usually start with a whimper, not a bang. If this does turn out to be the start of a bear market, we think there will be plenty of time for investors to assess the situation with care and discipline and make smart moves. Knee-jerk reactions, in our view, have no place in a long-term portfolio strategy.