Divergence in stocks and oil will continue for a while By Investing.com

Investing.com — Recent developments in the financial markets suggest that the long-standing relationship between stocks and oil prices has broken down, and this divergence is expected to continue in the near future.

Traditionally, these two asset classes have moved in tandem, often reflecting changes in global demand.

However, analysts at Capital Economics believe we are now entering a period where they will go their separate ways.

Over the past few years, the trends in oil and stocks have diverged significantly. While the price recently fell to its lowest level in nearly three years – dipping below $70 a barrel – the stock market, particularly in the US, saw only modest declines.

For example, it’s down just 3% from its peak in July, reflecting how disconnected these markets have become. The reason for this decoupling lies in the different forces shaping each market.

One of the key reasons behind the divergence is the influence of supply factors in the oil market. Unlike stocks, which are more sensitive to economic fundamentals and investor sentiment, oil prices have been heavily influenced by idiosyncratic supply issues.

OPEC+ decisions to extend production cuts, combined with a geopolitical risk premium, have created distorted supply dynamics in the oil market.

These supply factors, rather than changes in demand, have kept oil prices under pressure despite varying global economic conditions.

At the same time, equity markets, particularly in the US, were driven by very different factors. Enthusiasm over advances in artificial intelligence (AI) has injected a wave of optimism into the stock market, particularly among tech-heavy indices.

By mid-2024, this AI-driven optimism helped propel equity markets to new highs as investors bet on the transformative potential of AI technologies.

Even though concerns about the U.S. economy have temporarily dampened that enthusiasm in recent months, “we believe there is still room for the AI-fueled equity bubble to rebound and provide a boost to U.S. and global equities in the coming quarters,” the analysts said.

Another aspect of this divergence stems from the contrasting performances of China and the US in the global economy. China, a major driver of global oil demand, has seen its economic growth weaken, with crude imports falling year-on-year.

This slowdown has weighed heavily on oil prices, exacerbating the decline in global demand. However, this has not had a significant impact on global equity markets, which are more strongly influenced by the performance of the US and other advanced economies, where demand remains relatively stable.

“The US and other major advanced economies will avoid recessions this year, and the outlook for the future means that our view of the global economy is quite optimistic. We believe this will provide a positive environment for stocks to do well despite sluggish oil demand,” analysts said.

Going forward, the outlook for oil prices remains weak. With demand from China expected to remain low and OPEC+ likely to maintain a tight grip on production, oil prices are likely to remain under pressure for some time.

However, this continued weakness in oil is not expected to spill over into equity markets.

The divergence between these two asset classes, which has already been evident in recent years, is likely to persist as stocks continue to be supported by the performance of advanced economies and the ongoing technology revolution.

Instead, stocks have a more promising outlook. While there have been some concerns about the US economic outlook, Capital Economics expects a resurgence of optimism around AI, which could generate further gains in the stock market.

While there are risks – such as the potential for antitrust actions against big tech companies or geopolitical tensions – the underlying scenario remains positive.

The technology sector in particular is expected to play a key role in propelling equity markets higher, with AI acting as a major catalyst for growth.