The Surprising Reason Retail Sales Are Set to Rebound

Things are sure looking up for the average American. The job market, in terms of openings, is posting its best performance since the 1990s. Inflation remains in check. Economic growth has rebounded since stalling last winter. Heck, there's even a price war going on in the wireless industry, helping to push down monthly cell phone bills.

The good news rolls on: Thanks to a strong dollar and an increase in supply (as well as economic turbulence in Europe and Asia) crude oil prices look set to drop near two-year lows, providing some relief at the pump and freeing up cash to spend elsewhere, a boon to the retail industry. This is all the more surprising given the geopolitical tensions we've seen recently in places like Iraq and Ukraine.

Related: Commodity Prices, Bond Yields Send Warnings Signals

Wall Street has already connected the dots on this, as the SPDR S&P Retail ETF (NYSE: XRT) looks set to blast out of a long consolidation pattern that's held back stocks in the industry since November. Highlights include big reversals in beaten down names like J. C. Penney (NYSE: JCP) and Best Buy (NYSE: BBY) on anticipation of higher sales and more traffic.

XRT Chart
XRT Chart

XRT data by YCharts

Since the middle of June, futures prices on West Texas Intermediate crude have dropped more than 10 percent, from nearly $108 a barrel down below $94 a barrel. Prices are on track to test the lows near $92 a barrel set in late 2013 and early 2014. A break below that would put the early 2013 level near $86 in play, with additional support to be found around 2011-2012 lows near $77.

The team at Capital Economics is looking for prices to fall another 12 percent or so over the next year, reaching levels not seen since June 2012. They believe that U.S. economic sanctions against Russia and air strikes against ISIS extremists in Iraq have actually, on net, lessened the geopolitical risks to crude oil supply by diminishing the tensions in these two hot spots. Moscow seems more interested in a face-saving diplomatic solution as pro-Russian separatists in eastern Ukraine appear on the verge of defeat while Kurdish militants have recaptured territory from ISIS forces.

The U.S. even got the political change in Baghdad it wanted, increasing hopes of a more inclusive government that unites Iraq's three religious and ethnic factions.

Moreover, the Capital Economics analysts note that domestic shale oil production shows no signs of slowing (with the U.S. exporting oil recently for the first time in decades) while global energy inventories (including strategic reserves) remain ample. The U.S. shale production is locked as drillers become more efficient at pumping oil out of tight rock formations: Capital Economics notes that many companies say their marginal cost of production is below $60 a barrel, meaning that even if prices slump, the oil supply should continue to grow.

There have been a few unexpected surprises to help the situation as well, including the return of more than 200,000 barrels a day of light crude production from Libya despite political tensions there.

The newfound strength in the U.S. dollar has also played a role. Since the dollar is the global standard of trade for crude oil transactions, its vagaries directly impact the price of energy. A severe bout of weakness in 2010 and 2011 for the greenback, as the Federal Reserve conducted its $600 billion "QE2" bond purchase stimulus program, was accompanied by a rapid rise in oil prices from $70 to $114 a barrel.

Both oil and the dollar have been relegated to fairly broad sideways channels since then. But with the Fed's current "QE3" bond buying program set to end in October, and with chatter increasing about the timing of the liftoff from 0 percent interest rates, the dollar is catching a lift. It's also benefiting from the relatively higher yields offered by U.S. Treasury bonds compared to alternatives like German bunds (on 10-year notes, the yields are 2.4 percent vs. 1 percent respectively). The yield trade has been helped by the recent weakness in the euro.

^DXY Chart
^DXY Chart

^DXY data by YCharts

All this means crude oil could very well keep falling into 2016 and beyond as supply increases and the dollar keeps strengthening as a result of America's firming economy and the start of the Fed's policy tightening cycle. But what does it mean for consumers?

In 2012 Ross Devol, chief research officer at the Milken Institute, wrote in The Atlantic that every 50 cent change in the price of gasoline swings consumer purchasing power by $60 billion. Gasoline prices, on a relative basis, have actually dropped harder than oil prices and are down more than 13 percent from their recent high. Gas prices are at the lowest level, for this time of year, since 2010.

US Retail Gas Price Chart
US Retail Gas Price Chart

US Retail Gas Price data by YCharts

That's a big deal since gasoline prices didn't start their off-peak declines until September in 2012 and 2013. If the pattern holds true again this year, prices could drop rapidly in the weeks to come.

Holding demand for gasoline constant over the near term, as the government forecasts, and projecting a return in gas prices to their 2011-2012 lows near $2.44 a gallon would represent a drop of 68 cents. That should boost consumer purchasing power by about $82 billion on an annual basis — and could set the stage for a very strong holiday shopping season after a disappointing performance last year (partially driven by winter weather) that has kept retail stocks in stasis ever since.

Related: How Overvalued Is the Stock Market?

For investors, I believe retail stocks are where the profits of this dynamic are to be had. There have already been massive turnarounds in this area, including troubled teen retailers like American Eagle Outfitters (NYSE: AEO) and Aéropostale (NYSE: ARO). Given that gas money is a big chunk of the budget for the typical teenager, cheaper fill ups means more cash for tube tops and jeans.

Disclosure: Anthony Mirhaydari has recommended JCP calls, BBY calls and XRT to his clients.

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