This week we look at how
Oil Prices darken an already cloudy outlook
You will no doubt have seen media reports on the exceptionally volatile market conditions over the last couple of weeks due to the worsening economic impact of the spread of the Coronavirus. The volatility was increased further with the effective dissolution of OPEC+ on the weekend. After Russia did not commit to production cuts last Friday (which would have supported prices), Saudi Arabia slashed its selling prices in retaliation. This, combined with an already weak oil demand outlook due to Coronavirus, saw prices fall 25%.
The US sharemarket (as measured by the S&P 500 index) fell 7.6% on 9th March, the 19th largest fall since 1928 and the only daily fall since then greater than 7% outside of the Great Depression, WW2, the Global Financial Crisis and 1987’s Black Monday. As if to highlight the current volatility, yesterday the Australian sharemarket was up 3.1% and overnight the US sharemarket was up 4.9%. This kind of incredible volatility is likely the new normal.
Systematic investment strategies, increased bank regulation and growth in passive investment strategies mean markets are likely to be dysfunctional, mispricing risk both in calm and volatile times.
The collapse in oil prices in and of itself isn’t necessarily a material cause for concern. Oil prices have fallen significantly in percentage terms but are only around $30 per barrel lower than in January this year. In the nearly two years from mid-2014, the oil price fell $80 per barrel, from around $107 to $26 per barrel. During the 2014 collapse, the number of shale rigs producing oil in the USA fell from around 1600 to around 300. Currently, there are only 600 rigs in operation given the low starting oil price, though this is likely to fall significantly if oil prices hold where they are. On net, we expect the impact on the US economy from this fall in prices to be less than that faced in 2014 and 2015.
A key consideration is the collapse in oil prices on the value of Corporate Bonds issued by Energy companies. Energy companies have borrowed huge sums of money in recent years to increase production however their ability to repay these loans is predicated on oil trading at a higher price than it is currently. In addition, when these loans are taken out, they have a credit rating assigned to them – effectively the market assigning a measure on the prospects of the borrower (i.e. the Energy companies) being able to repay interest and principal as required.
The higher quality loans are typically referred to as Investment Grade whilst the lower quality loans are referred to
as High-Yield or the less flattering term of “Junk”. In 2014, the energy sector accounted for around 15% of US Corporate Bond indexes1. While this currently stands at only around 10%2, the overall credit quality of US corporates has deteriorated since 2015. In particular, there is a huge amount of debt trading just on the cusp of Investment Grade. It will not take much of a market shock to have the credit rating of these loans downgraded to High Yield or Junk status, triggering a period of forced selling by institutions which are mandated to hold Investment Grade credit and passive products. The emergence of listed corporate bond Exchange Traded Funds promising liquidity over an illiquid investment presents an additional challenge to the asset class. The market could fall significantly if investors rush to exit at the same time, which is likely in the event of mass credit rating downgrades. This is a risk we have been concerned about for a while and has the potential to turn a short-term external economic shock (Coronavirus) into a systemic risk issue, which would be a catalyst for a much larger fall in sharemarkets.
Pivoting back to the more clear and present danger to the global economy – the Coronavirus pandemic – the news over the past week has been mixed. On the positive side, it seems as though South Korea has been getting a handle on its outbreak. The number of new daily cases has fallen by nearly a half over the period due to extensive countermeasures. Other countries such as Singapore, Japan and even China have also demonstrated remarkable success in containing outbreaks. We now have available a blueprint to follow in the rest of the world to limit the impact of the virus. Unfortunately, that blueprint comes with a meaningful economic impact. To varying degrees, schools, shops and offices have been closed, freedom of movement has been restricted, personal privacy has been forgone.
It also seems that delayed action requires a larger response. Trying to stem its own outbreak, on Tuesday Italy locked down the entire country, telling people to stay home unless the reason for travel is work, medical reasons or an emergency. To put the speed of required action in context, on 25 February (around two weeks ago), Italy had 322 confirmed cases, by March 9 there were more than 9000. Put another way, Italy has gone from the same number of per-capita cases as Australia currently has, to locking down the country completely in 14 days.
The problem is that all of this (falling oil prices, credit market dislocations and Coronavirus) is happening at the same time, and as evidenced by recent market moves, creating huge uncertainty and elevated market stress. In times such as these, the sum of risk is greater than the parts. Governments are announcing more stimulus (payroll tax cuts in the USA for example), but we don’t think this will be enough to offset the compounding weakness, at least initially.
While the short-term outlook is still negative, we are quite positive on the medium-term outlook for global sharemarkets.
In our view there are two main areas that could stabilise and revive sharemarkets;
- Interest rates remain low and global Central Banks are responding with further interest rate cuts. In addition, Governments have delivered or are promising stimulus packages to offset the effects of the Coronavirus and associated quarantine measures.
- Sharemarket valuations are now less expensive and much closer to long-term averages compared to the recent elevated levels.
As you know, our message is always that as long-term buy and hold investors we need to accept sharemarkets will have these periods of heightened volatility and are not to be feared as they are an accepted part of investing.
Indeed at times of market stress when other investors are selling, the long-term patient investor is able to step in and provide liquidity to the market in return for the potential for greater returns looking forward.
The most successful investors take advantage of the fear and gloom, using these tumultuous periods to invest money at bargain prices. The best opportunities come in times of maximum pessimism.
Once the wave of the Coronavirus passes, and if credit markets do not unleash systemic risks, we will be left with a
global economy awash with huge stimulus and consumers that are ready to spend given pent up demand built up during lockdowns.
1 https://www.bis.org/publ/qtrpdf/r_qt1503f.pdf
2 https://www.ssga.com/library-content/products/factsheets/etfs/us/factsheet-us-en-jnk.pdf
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