In October 2021, I wrote a Chart of the Week about natural gas and energy prices being high and how it seemed that inflation was going to be longer lasting than initially expected. I wondered if energy companies would start to increase capital expenditures to match supply and demand, and if the energy industry would shift back into favor with investors. However, a Russian invasion of Ukraine and the resulting devastation were not at all on my radar. Our hearts go out to the people of Ukraine, their loved ones and all those affected.
As the Ukrainian people continue to display bravery defending their country, other countries have been showing their support for Ukraine. The U.S. and European nations have instituted sanctions and further measures are being contemplated. As a response, Russia is limiting its exports. Realizing that there is a tight supply in most commodities globally, the export restrictions from Russia and the loss of production and export capacity from Ukraine have created a chain reaction globally.
For example, the higher energy costs in Europe (for natural gas, in particular) have led to the shutdown of factories, ranging from fertilizer plants to containerboard mills. It is evident that certain costs have moved too high and producers have been responding rationally — but what will be the breaking point for consumers? In the U.S., gasoline prices at the pump have increased faster in the past week than during any other week in history, and now stand almost 50 cents per gallon (+13%) higher than the previous week!
As I discussed in October, higher prices can ultimately diminish demand or incentivize producers to increase supply, which could eventually exceed demand and result in lower prices. This week’s chart demonstrates that we are seeing higher prices today across the board. The white line in the chart reflects the Commodity Research Bureau’s (CRB) All Commodities Index, which measures the price movements of 22 sensitive basic commodities (ranging from raw materials in metals, t0 textiles and fibers, livestock and foodstuffs like hogs, soybean oil, corn and wheat, to name a few). This basket of commodities, according to the CRB, is among the first to be influenced by changes in economic conditions and can be an early indicator of impending changes in business activity.
Looking back over the past 30 years, we can see that it is common for the CRB All Commodities Index price to increase rather strongly coming out of recessions (red shaded bars). Following the COVID-19-induced recession in early 2020, we were experiencing a similar pattern of higher prices. The Russian invasion of Ukraine in February 2022, however, is leading to increased inflation.
The removal of basic commodities from global supply has caused inflation to spiral higher. The higher inflation, in turn, could eventually force consumers to choose between heating their homes, buying food, refueling their cars or getting on that plane to go on vacation. If these commodity price levels stay elevated at 30-year highs, there will be less discretionary spending capacity by consumers. This may be beneficial to the commodity producers that can continue to operate, but it will likely come at the expense of many other industries.
The orange line in this week’s chart reflects the Bloomberg U.S. High Yield Index Option-Adjusted Spread in basis points (bps). It is worth noting some key historical events and how they relate to the CRB All Commodities Index. First, during the last three major recessions (2001, 2008/09 and 2020) high yield credit spreads increased materially to reflect the economic weakness and elevated default rates (unfortunately, it was not much of a leading indicator).
Second, U.S. high yield credit spreads today remain more than 100 bps below the long-term average of 496 bps (as depicted by the dashed white line). If this inflation will benefit the energy producers (~13% of the U.S. High Yield Index), that sector could be one area of outperformance, but the majority of the other sectors will potentially experience materially weaker results. The benign default environment that we are currently in could start to shift, which could result in higher high-yield spreads (to compensate investors for potential losses from default).
It goes without saying, the higher prices for goods globally pales in comparison to the devastation that Ukraine is experiencing, and we need to keep that in perspective. Along the same lines, the costs of this war for Russia, and Putin in particular, seem to be escalating exponentially as well.
From a market perspective, the risk is that inflation will continue to lurch higher and ripple throughout the world. How long these prices stay elevated and how much inflation we can handle will also impact the U.S. Federal Reserve’s rate hikes and quantitative tightening. At the start of 2022, we were clearly already in the midst of significant inflation, but the consumer has been very strong and corporate defaults have been very low. This strong consumer and low default rate have been reflected by U.S. high yield credit spreads. If this war continues and supplies continue to be constrained, expect high yield credit spreads to move higher and the energy sector to continue to outperform.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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