This would be expected to create some headwinds for the economy, which in turn could exert downward pressure on the stock market and dampen stock prices. Admittedly, this would likely occur with a significant lag and, given that its effect is usually limited, I believe it should not be a significant concern in the near term — but it is not something we should entirely ignore.
Then there is the impact that rising oil prices may have on the 10-year US Treasury yield. In the past year, there has been a positive correlation between oil prices and the 10-year Treasury yield. This makes sense given that the yield on the 10-year Treasury is widely viewed as a gauge of expectations on global growth and inflation. With rising oil prices placing upward pressure on inflation, I expect the 10-year US Treasury yield would continue to move higher, so long as global growth remains solid.
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This in turn may cause a re-rating of stocks as the 10-year yield pushes through key levels and pressures valuations. As the International Monetary Fund (IMF) warned back in January, “Rich asset valuations and very compressed term premiums raise the possibility of a financial market correction, which could dampen growth and confidence.” We have seen this occur several times in the past few months, with the 10-year yield hitting new key levels, which have in turn prompted short-term stock market sell-offs.
Key takeaway
And so, in the shorter term, I would not be surprised to see oil prices rise, pushing the US 10-year Treasury yield higher and causing another re-rating of stocks. However, I believe an increase in US oil production will partially counter the void created by the loss of supply from Iran and Venezuela — albeit with a lag. And I believe stock market fundamentals remain solid, helping to support stocks following knee jerk re-rating sell-offs as the 10-year yield rises. So investors should expect higher volatility for equities in this environment.
Perhaps most importantly, rising oil prices are an important reminder that inflation protection may need to be a serious consideration for investment portfolios — especially given that there are a variety of inflationary pressures at work. There are several asset classes that may help mitigate the downside effects of inflation, including: commodities.
If the prices of goods and services are rising, then the price of commodities may also be rising at a similar level, real estate, for the same reason as commodities. dividend-paying stocks, these may offer a hedge against inflation if companies increase their dividend payouts at a pace that meets or exceeds the pace of rising prices. Inflation-protected securities. In general, the outstanding principal of these bonds is tied to inflation — this means the principal goes up when inflation goes up, and therefore the interest paid on that principal rises as well.
Some of the best known are TIPS (Treasury Inflation Protected Securities, issued by the US government) and LINKERS (issued by the UK government).
This article has been republished with permission from Invesco Powershares.