How higher energy prices may impact portfolios

Frank Talbot, Head of Investment Research at Albemarle Street Partners, explores how sustained elevated energy prices could shape markets and portfolio strategy.

Key takeaways:

• Oil markets
  • Futures contracts are pricing in a scenario where Brent Crude falls to around $80 a barrel by the year end, implying the expectation of a relatively swift resolution to the conflict in the Middle East*
  • Nonetheless, a prolonged period of $90+ oil remains a credible risk, with implications for various asset classes

• Government bonds
  • Rising energy costs are pushing inflation expectations higher, weighing on government bonds, although they should rally if the conflict is resolved quickly
  • However, sustained high energy costs may trigger a recession which in turn could lead to lower interest rates
  • Government bonds tend to fare well in a recession, but in the tail risk scenario of stagflation, they will suffer

• Corporate bonds
  • Corporate bonds are benefitting from strong earnings and balance sheets and have not been as impacted on a relative basis as government bonds
  • However, a prolonged period of conflict and higher energy costs will weigh on corporate profitability. 

• Equities
  • Energy-intensive sectors such as industrials and aviation face headwinds
  • More defensive areas – including healthcare, financials, utilities, infrastructure and consumer staples – are likely to prove more resilient

• US equities
  • The US, as a net energy exporter, enjoys a cushion relative to its developed market peers, particularly given its ability to hold or increase rates given its higher economic growth.
  • This has led to a significant rally in the US dollar, reinstating its place as a safe haven currency 

• Portfolio positioning
  • Diversification remains key amid uncertainty
  • In February, Albemarle reduced exposure to Gilts, European and smaller companies, and reallocated much of its government bond exposure to short duration debt
  • As short-duration debt is close to cash, this offers the opportunity set of redeploying capital once the situation improves
  • This is likely to favour credit markets which have stronger mean reversion characteristics, before assessing opportunities in equity markets