Andrew Sheets: Are Oil and Stock Prices Now Disconnected?

While oil prices usually rise and fall with the overall stock market, current prices have broken from this trend and oil may continue to outperform on a cross-asset basis.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, May 6th, at 2 p.m. in London.

Yesterday, U.S. equities fell more than 3% and U.S. 10 year Treasury bonds fell by more than 1%. This unusual pattern has only occurred 6 other days in the last 40 years. Markets are clearly continuing to struggle with major cross-currents, from a Federal Reserve that's raising interest rates, to mixed economic data, to the war in Ukraine.

But one asset that's bucking the confusion is oil prices. Oil usually rises and falls with the overall stock market because the prices of both are seen as proxies for economic activity. But that relationship has broken down recently. As stock markets have fallen, oil prices have held up. We think that oil will continue to outperform on a cross-asset basis.

Part of this story is fundamental. Demand for energy remains high, while energy supply has been slow to grow. The green transition is a big part of this. Consumers are likely to shift towards electric vehicles, but most cars currently on the road still burn fuel. Energy companies, seeing the shift in energy consumption coming, are more reluctant to invest in new production today. This has left the global oil market very tight, without much spare capacity.

There's also a fundamental difference in the way asset classes discount future risks. Equity and credit markets are very forward looking, and their prices today should reflect how investors discount risks over the next several years. But commodity prices are different; when you need to fill up a car, or a plane, you need that fuel now.

That distinction in timing doesn't always matter. But if you're in an environment where economic activity is strong right now, but it also might slow in coming years, equity and credit markets can start to weaken even as energy prices hold up. I think that's a pretty decent description of the current backdrop.

A final part of this story is geopolitical. Oil prices could rise further if the war in Ukraine escalates, a scenario that would likely push prices down in other asset classes. But if geopolitical risk declines, there could be better growth, more economic confidence, and more energy demand, meaning oil might not fall much relative to forward expectations. That positive skew of outcomes should be supportive of oil.

In the short term, high oil prices could weigh on consumer spending. In the long run, it creates a more powerful incentive to transition towards more energy efficiency and newer, cleaner energy sources. In the meantime, we forecast higher prices for oil, and for oil linked currencies like the Norwegian Krone.

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