Why Falling Oil Prices Are Causing Stock Market Ripples
Though low oil prices are normally considered beneficial for the economy, this year’s deepening slide has been blamed for much of the recent weakness in global stocks. Oil is playing an especially influential role for several reasons, starting with the fear that sagging prices may foreshadow a coming deterioration in global growth. That is likely not the case, as the fundamental underpinning of the U.S. economy appears to be intact.
At the most basic level, the decline in crude oil is being driven by a mismatch between supply and demand. Unlike the past, when OPEC reduced supply to prop up prices, Saudi Arabia and other oil-producing nations continue to pump at extremely high levels as they compete for market share against U.S. shale operators. The expectation that Iran will boost exports following its nuclear agreement with the U.S. is also having an effect.
Despite the widespread perception that demand for crude oil has plummeted, it has actually increased. Certainly, the appetite for oil has weakened in some areas of the world, such as in the emerging markets. But global demand continues to rise overall. For example, lower gas prices have sparked a notable increase in driving among U.S. motorists. Meanwhile, China and India have been adding to their strategic petroleum reserves.
Still, as supply outstrips demand, there is concern that China’s economy may be slowing even more sharply than assumed and some of that weakness may spill into the U.S. Given the tightly woven nature of the global economy and financial markets, a hard landing in China would indeed affect the U.S. Though American exports to China are relatively small, U.S. exporters sell to other countries, including those in Europe, that have greater trade linkages to Asia.
Additionally, there is fear of a financial contagion taking hold in the capital markets, particularly the credit market. The 2008 financial crisis showed that duress in one part of the world can seep into the global financial system. Recently, the high-yield market has suffered because investors fear defaults by small energy companies. That has made it harder and more expensive for companies in unrelated industries to secure financing. Banks have boosted loan reserves in anticipation of higher energy-related losses.
However, all these recent developments should be put in context. The chance of contagion is very low, in part because the financial system is much stronger than it was in 2008. U.S. non-governmental debt ratios are lower, and bank capital reserves are much sturdier. The domestic job and housing markets are strong, and some signs even point to economic stabilization in China.
“There’s no doubt that it’s a challenging situation, but I expect that the U.S. economy will be able to withstand the effects from China and the energy market,” says Capital Group economist Darrell Spence.
Beyond that, Spence says, low energy prices have historically been positive for the economy, as falling gas costs spur consumer spending.
“Lower gasoline prices are a pretty big benefit to U.S. consumers, who make up 70% of the economy,” he says.
It’s also important to understand that energy plays a far bigger role in the equity market than in the actual economy. The energy industry’s contribution to U.S. GDP is quite modest ― only 1.4% (down from 2.5% or so before oil peaked in early 2014). In contrast, energy companies have a much higher weighting in the market capitalization of the S&P 500 ― 6.5%. (That’s down from 10.5% in 2014.) The higher weight is due partly to energy companies being inherently capital-intensive and needing to raise equity financing. Thus, the decline in energy stocks has a bigger impact on the stock market than on the underlying economy.
Volatility is likely to remain elevated in both the energy and stock markets in the near term. While the recent decline in equity prices has been unnerving, remember that periodic corrections are a normal component of investing. The best strategy is to maintain a long-term investment approach that can ride out temporary fluctuations.