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The energy-inflation connection can’t be ignored

Contributor
  • Jordan Stuart

    Client Portfolio Manager

There’s only so much innovation can do as accelerating growth drives up demand.

In my calls with investors around the country over the past few weeks, their No. 1 question has been, “Where do you think inflation is heading?” This is followed by, “How soon could it affect the economy?” Unfortunately, there are no definitive answers. But, as we come out of our pandemic restrictions with historic levels of fiscal stimulus and favorable Federal Reserve policy, it’s understandable that investors are worried about the possibility of rising inflation and its impact on the economic recovery. Consider that commodity prices—oil, agricultural goods, metals—have risen significantly. The Commodity Research Bureau Index is up more than 40% over the last 12 months.

So, why hasn’t this derailed the stock market? Most recently, Covid-19 restrictions have played a role, with several categories experiencing direct and indirect disinflationary effects from the pandemic: airfares, commuting costs, apparel, financial services and travel. Moreover, during the past two decades, innovation has by far played the biggest role in suppressing inflation. Our means of production have become dramatically more efficient, as has our use of resources. With technology driving the production of more goods and services, companies in all industries have achieved lower production and labor costs. Over the same period, the prices of computers and electronic devices have been declining, benefitting business and consumers alike.

INNOVATION HAS ITS LIMITS

There’s one area, however, where innovation might not come to the rescue as quickly as we need it to: producing the energy to run our economy. Oil continues to dominate our energy mix despite its impacts on the climate, geopolitics and its ability to cause global economic gyrations. Apart from the pandemic recession, every recession since 1973 has been preceded by a jump in interest rates and oil prices. The last time we had a major oil spike, in 2007-2009, innovation via the fracking revolution helped generate an additional 20-30% of global supply and made the U.S. the world’s largest energy producer.

Today, the electrification of vehicles, hydrogen power and other energy sources such as wind and solar are unlikely to fill the void fast enough despite great strides in new technologies. Even the electrification of vehicles will require a minimum 10- to 15-year time frame given the limits of our electric grid, consumer adoption and current vehicle life cycles. In the meantime, if oil prices continue to ramp up as they have over the last six months, the past few weeks aside, we may see unwelcomed consequences in the form of slower growth and/or higher inflation as rising energy costs ripple across every sector of the economy and potentially slow the recovery. 

WHAT’S THE BEST COURSE FOR INVESTORS?

While post-pandemic momentum may drive economic and market performance for a time, it’s a company’s earnings, cash flow and ability to innovate that have the best chance of powering it through tough times—whether caused by inflation, oil prices, rate spikes or an economic downturn. That’s why we believe the best defense is to be highly selective. The angst surrounding Treasury yield and oil price movements illustrates their strong ties to economic growth and the markets. Proven, credible innovators—including those striving to solve our energy conundrum—have years of runway for their products to grow. These are companies that exhibit secular growth opportunities that can transcend rate fluctuations and other top-down economic worries as these companies focus on solutions that will shape the global economy for years to come.

DISCLOSURES
Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Stocks are subject to risks and fluctuate in value.

The Commodity Research Bureau Index measures the overall direction of prices across commodity sectors.

Federated Advisory Services Company

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