Energy stocks, surprising leaders

In this article, Russ Koesterich discusses the YTD strength of energy stocks and why it could continue.

Key takeaways

• While many of last year’s themes continue to dominant markets, there is one thing that is different: the energy sector.
• Year-to-date, the U.S. energy sector has posted a 10% gain, roughly in-line with the broader market.
• Russ believes there are several factors supporting the sector including elevated commodity prices and elevated inflation, as well as valuations and its role as a hedge.

Equities have recovered from their April slump and are once again posting new highs. While the rally has broadened, several of last year’s themes, including artificial intelligence (AI) and semiconductors, continue to lead. However, there is one change to note: Unlike last year, when it dramatically underperformed, the energy sector is holding its own so far this year. My own view is that the sector can continue to advance.

Several factors support further gains, including a surge in commodity prices, still elevated inflation, cheap valuations, and the sector’s role as a hedge against geopolitical uncertainty.

Sticky inflation, surging commodities

Energy stocks are benefiting from a resilient economy which has, in combination with select supply constraints, supported the broader commodity complex. Year-to-date, the S&P GSCI Commodity Index is up more than 10%. Depending on the universe, crude oil is up roughly 10%, with other parts of the energy complex, notably gasoline, posting solid double-digit returns.

This rally in commodities is occurring against a backdrop of still elevated inflation. While price gains have decelerated, both core and headline inflation remain comfortably above 3%. This is important as the sector’s performance tends to move with both expected and realized inflation.

During the past two years the S&P 500 energy sector has had a positive correlation with changes in short-term inflation expectations (~0.3), derived from the Treasury Inflation Protected Securities (TIPS) market. In contrast, the broader market has had a negligible relationship with changes in inflation expectations. Put differently, energy stocks may benefit from rising inflation expectations more than other parts of the stock market.

Recent patterns conform to longer-term trends. Historically, the relative performance of the energy sector has been positively correlated with the rate of inflation. Going back to 1995, whenever inflation has been below 3% year-over-year, the S&P 500 Energy sector has generally underperformed, trailing the market by an average of approximately 0.40%/month. However, in periods when inflation has been 3% or greater, energy stocks post positive average returns of around 0.90%/month.

Still on sale

The third factor favoring energy stocks is valuation. Of the 11 GIC sectors energy is by far the cheapest. The current valuation, roughly 11x forward earnings, is also well below the sector’s long-term average (see Chart 1).

Global equity valuation by sector

Energy stocks, depending on the catalyst, may provide one additional advantage: helping to hedge geopolitical risk. While the market has thus far looked past growing geopolitical instability, the conflicts in Ukraine and the Middle East are not abating. Despite it often proving profitable to ignore temporary eruptions in geopolitical risk, from an economic standpoint the events in Ukraine and the Middle East are distinguished by their potential impact on energy prices, whereas an increase in tensions could result in a spike in pricing. In addition to the other factors favoring energy, it is worth remembering the sector’s role not only as an inflation hedge, but as a geopolitical one as well.

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