Citi: What does the oil shock mean for the course of the shares – Is there a sell-off or a rally?

Her Eleftherias Kourtali

Citigroup examines the four recent oil shocks and concludes that 12 months later, the MSCI World Index was twice as high (1979, 1990) and twice as low (1974, 2000). This happened despite the financial weakness in each case. As he estimates, world stocks are not a clear sell just because the price of oil has skyrocketed.

More specifically, as he notes, Brent has just broken the three-year moving average and Citi identifies four similar events: 1974 (OPEC embargo), 1979 (Iranian revolution), 1990 (Gulf War), 2000 (end-of-cycle boom).

The oil shock has always been negative for economies, notes the American bank. The US ISM fell below 50, indicating an economic contraction, after each of these shocks. The current ISM (58.6) indicates a strong momentum, which will help limit the damage.

At the same time, this shock was not always negative for the shares. The return on global equities following the oil crisis is unclear. MSCI World fell 30% 12 months after the 1974 and 2000 oil highs, but rose 10% in the 12 months following the 1979 and 1990 peaks.

The shocks of oil

Brent was already approaching $ 100 before the conflict in Ukraine. It jumped to $ 128, but has fallen since then. But what is an oil shock? As Citi points out, first, not all oil price increases are the same. A 300% increase in the 12 months to April 2021 (to $ 65) was less worrying than the 60% increase that has since risen. The first represents a “good” increase in oil, due to the recovery of global demand. The latter is a “bad” increase, due to threats to oil supply.

The usual correlations of oil with stock markets miss this important distinction. Brent recently moved to twice the three-year moving average (currently $ 60). This has happened only four times in the last 50 years: 1973-74 (OPEC embargo), 1979 (Iranian revolution), 1990 (Gulf War), 2000 (end of cycle). As of now, the first three were linked to a geopolitical event that threatened a major supply disruption. The biggest move was in 1973-74, when oil jumped to three times the three-year average.

What does history suggest about the further course of oil? According to Citi analysis, Brent six months ago and 12 months after it reached the definition of “launch” (twice the three-year moving average). This could be a signal for oil, with prices falling by an average of 10% a year later. Only in 1974 and 1979 did Brent manage to maintain its profits. Presumably, this reflects the fall in demand and the increase in supply on the rise. ΤHowever, oil has a significant reversal, Citi notes, and analysts estimate that Brent will fall again to $ 79 / barrel by the end of this year.

Shares: Not always sell

How did the stock fare after these shocks? Surprisingly, they do not always give up, Citi points out. In the 12 months since Brent’s previous peaks, MSCI World fell 30% twice (1974, 2000), but also strengthened 10% twice (1979, 1990). This may in part reflect the fact that stocks often fall in advance, as is the case this time around.

This mixed stock return came despite financial weakness. The ISM in the US fell sharply after the previous four oil peaks. A level below 50 indicates economic contraction and therefore a drop in corporate profits. The US economy (ISM 58.6) is heading for this oil shock with better momentum than in the past (average 52.3), which may limit the downward movement. Developed economies are less energy-intensive than in the past, which should also reduce losses.

History even disputes the common belief that a large increase in oil will inevitably push inflation higher. US inflation rose 12 months after peaks in 1974 and 1979, but fell in 1990 and 2000. The current level of inflation (6%) is similar to the average of previous peaks.

Also, the Fed funds rate (0.5%) is much lower now than it was in previous oil shocks (average 8.6%). Perhaps this sends a downward signal to stock markets that interest rates need to rise much further to bring inflation under control. Or it could be supportive. Even with potential increases over the next two years, cash positions seem likely to remain an unattractive strategy. In the past, as central banks chased oil prices and inflation higher, high and rising cash positions returned absorbing funds from stocks, pushing valuations down. Prices will also rise this time, but not back to the levels seen after previous oil shocks, Citi estimates.

This combination of very low interest rates with rising inflation means that real interest rates are likely to remain below zero in the near future. The shift to negative real interest rates proved extremely supportive of global equities during the economic downturn during the pandemic. In 2020, MSCI World grew by 15%, despite a drop in earnings per share (EPS) by 22%, while growth stocks did particularly well.

MSCI World is currently trading a fairly expensive 19x P / E which could make it vulnerable. It is much more expensive than 9x in the shock of 1979 (when MSCI World was 10% higher 12 months later). However, current valuations are well below 28x in the 2000 uptrend (when MSCI World was 30% lower 12 months later).

Also, as Citi points out, global stocks are much cheaper than bonds compared to previous oil crises. The profit margin is now at +340 basis points, compared to an average of -29 bp observed in the previous four examples of oil crises. Like cash, bonds do not look like an attractive investment this time around, especially for those investors who are worried about higher inflation. Despite the fact that earnings per share are likely to be under pressure, there is still no alternative to owning shares, the US bank concludes.