Why the stock market keeps changing its story

Exxon is at the heart of two stories: Strong demand for oil because the global economy is stronger than expected, and supply problems because of wars in Ukraine and the Middle East. ILLUSTRATION BY ALEXANDRA CITRIN-SAFADI/WSJ
Exxon is at the heart of two stories: Strong demand for oil because the global economy is stronger than expected, and supply problems because of wars in Ukraine and the Middle East. ILLUSTRATION BY ALEXANDRA CITRIN-SAFADI/WSJ

Summary

Exxon’s surge is an important shift in the market, a new narrative that investors would be wise to pay close attention to—in case it changes again.

As the Magnificent Seven are downgraded to the Fab Four, perhaps the list of leading tech stocks should include an old-school name: Exxon Mobil.

The oil company’s shares would come in fourth in the septet this year with a rise of 21%, after Nvidia and Meta and very close to Amazon. Behind Exxon’s surge to a new high on Friday is an important shift in the market, a new narrative that investors would be wise to pay close attention to—in case it changes again.

Exxon is at the heart of two stories: Strong demand for oil because the global economy is stronger than expected, and supply problems because of wars in Ukraine and the Middle East. Both were on show this week, as oil rose on strong jobs figures Friday, a day after it was pushed up by concern of Israel-Iran escalation on Thursday. Oil stocks are winners from both stories, while most of the market prefers one or the other.

Until recently, investors had been focused on falling inflation bringing down bond yields. That was good for growth stocks, already winners thanks to excitement about artificial intelligence.

Markets haven’t forgotten about inflation, but they put it aside in favor of a focus on the stronger-than-expected economy, which boosts demand for oil. The S&P 500 energy sector, the biggest member of which is Exxon, is now ahead of the tech sector for the year and on Friday passed communication services, in which Meta and Alphabet sit, when dividends are included.

The energy sector’s valuation has risen to its highest since the Federal Reserve started raising interest rates in March 2022, using the price-to-forward-earnings ratio.

Investors love to distill the bewildering variables that move prices around into a single narrative. Once enough people agree on “what’s driving markets" then the narrative can be self-fulfilling—until of course, something interrupts the story and the narrative changes. Oil, like gold, is in the unusual position of benefiting from two competing themes, a hot economy and geopolitical threats.

It helps to look at the market’s recent history. There was a huge change in the narrative back in October when 10-year Treasurys hit 5% and previously hawkish Fed officials turned dovish, worrying that high bond yields would hold back the economy. Yields plunged and the stock market took off, supported by Fed Chairman Jerome Powell’s “Powell pivot" toward rate cuts. Investors priced in six rate cuts this year by the start of January, and every hint of lower rates pushed up stocks further.

In January, the story began to move to the economy. It became clear that growth was stronger than thought, and the Fed underlined its forecast of only three rate cuts. Rather than worrying that rates would be higher than expected, investors cheered the prospect of fewer cuts as a sign of a solid economy. The switch from good news on the economy being bad news for stocks to being good news for stocks was complete.

The problem with growth is that it has limits, and at the heart of those limits is the oil price. When demand rises broadly in the economy, the oil price rises, and more of consumers’ money is spent at the pump. Too much demand, and the rising price means the rest of the economy loses out.

The same goes for other commodities, to a lesser extent, with manufacturers surveyed for the latest S&P survey of purchasing managers reporting sharply higher input costs in March and raising their own prices at the fastest rate in almost a year.

The danger for investors is that recent rises in inflation-sensitive oil, gasoline, copper and gold—the yellow metal hit a new high on Friday—are a signal that economic growth will lead to a second round of inflation, forcing investors to flip back to worrying about rising prices again.

The stronger economy has also pushed at the financial limits of growth, encapsulated in rates. Yields on 10-year Treasurys rose sharply this week to briefly hit 4.4% Tuesday, spooked in part by the PMI figures, and came close to that on Friday after the strong job numbers—although they are still well below the October peak of 5%.

One warning that the narrative might be changing yet again: Tuesday’s jump in bond yields flipped stock investors back to treating higher yields as bad news again, with stocks falling when borrowing costs went up. That comes after months of markets broadly treating higher yields as a symptom of stronger growth and thus good news.

Shamik Dhar, chief economist of BNY Mellon Investment Management, thinks the big change in narrative will come if markets switch from pricing fewer rate cuts by the Fed to preparing for actual rate rises. “Then you get a major narrative change," he says. “Markets like relatively simple stories to hang their hat on."

So does Exxon belong with the tech biggies? It isn’t a tech stock, but then Amazon is a retailer, Apple sells music and consumer goods and Tesla makes cars. Where it’s different is that oil producers don’t only thrive on growth-driven inflation. They also benefit from problems on the supply side—of which there are plenty. Ukrainian strikes on Russian oil facilities, Yemeni attacks in the Red Sea and the threat of an Israel-Iran conflict all support oil prices, as well as the haven of gold.

Non-energy stocks, especially cheaper value plays, should do OK in a period when growth is pressuring inflation up, but not outrageously so. But an oil supply shock helps only the oil stocks, with the rest suffering from weaker growth, recession or even stagflation.

It is too soon to know which way the narrative is headed. My bet continues to be on sticky inflation pushing central banks to hold back on rate cuts, which should eventually slow the economy. For now, oil stocks offer an alternative way to bet on growth—and some protection if geopolitics brings the growth story to an end.

Write to James Mackintosh at james.mackintosh@wsj.com

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