A Crude Awakening
The latest wild card couldn’t have come at a worse time.
Our Top Market Takeaways for the week ending March 09, 2020.
Another draw from a deck stacked with wild cards
Over the weekend, Russia and Saudi Arabia abandoned their agreement to curtail oil supply in an effort to support prices. Russia was tired of playing along with the Saudis, and refused to further cut production. In response, the Saudis dropped their official selling price for crude by the most in 20 years and signaled that they would likely ramp up production. Brent crude prices dropped from their Friday trading range of $45–$50 per barrel to ~$35 per barrel at time of writing. Brent prices are down almost 60% from their recent peak in September 2018.
The return to a fight for market share among oil producers is bad news for financial markets. The S&P 500 is down almost 6% after hitting the circuit breaker when the market opened. The Nikkei ended down 5%; Hong Kong’s Hang Seng dropped 4.2%, and European markets are down anywhere from 5.5% (Switzerland) to 11% (Italy). U.S. 10-year Treasury yields are trading below 50 basis points (bps) for the first time ever. The market is pricing that the Fed will cut interest rates to zero by the middle of the year.
The breakdown of the OPEC+ agreement is another wild card that is being played at exactly the wrong time for financial markets and the economy. The situation is extremely fluid, but this is our initial sense for how the move in oil prices will interact with COVID-19 in the coming weeks, months and quarters. Bottom line: The move in oil prices is a clear negative for financial markets, and spillover from financial market pain to real economy weakness is becoming more and more likely.
Bottom line: The move in oil prices is a clear negative for financial markets, and spillover from financial market pain to real economy weakness is becoming more and more likely.
Consumer: All else equal, lower oil prices are a positive for U.S. consumers. Indeed, last year U.S. consumers spent around $350 billion on gasoline and other fuel oils, so any reduction in price helps keep more money in the average American’s checking account. The problem is, that only represents less than 2.5% of total personal consumption expenditures (down from ~4% during the halcyon days when Brent was trading above $110 per barrel). For consumers, this reduction in oil prices is very similar to the reduction in consumer borrowing costs from the decline in interest rates. Yes, it is a positive, but it seems like a much more powerful force (uncertainty in the face of COVID-19) is likely to stifle demand. The silver lining is that the consumer balance sheets are still very healthy, and a reduction in consumer-facing interest and energy costs helps maintain that position. But it would be overly optimistic to expect a spending surge on the back of these reduced costs.
Rates: Rates are very unlikely to rise materially anytime soon. Thirty-year Treasury yields are below 1%, 10-year Treasuries are below 50 bps, and 2-year yields are at 30 bps. And globally, some 25% of investment grade bonds are yielding less than zero. Why does oil matter to rates, anyway? It all goes back to inflation expectations. Gas prices are one of the prices that factors most prominently in consumers’ minds. Because of this, it has an outsized effect on inflation expectations, and inflation markets (think things like TIPS) are priced off of headline CPI. As the price of oil declines, inflation breakevens (which do enter into the Fed’s calculus) decline as well. Inflation is even less of a threat, and investors have a reason to pay high prices for the relative safety that Treasuries provide. Right now, the market expects the Fed funds rate to be back at zero by July.
The line chart shows the Fed funds target rate from 2015 through March 3, 2020. It also shows future market expectations for the Fed funds rate to go back to 0%.
Unemployment and investment: The shale revolution altered the United States’s relationship with oil prices forever. However, there may be less employment exposure to oil and gas employment than meets the eye. There are 90,000 Americans currently employed in non-supervisory oil and gas extraction roles, down from the 2015 peak of 110,000. When crude prices fell 60% from May 2015 to early 2016, oil and gas employment fell by a third to just over 70,000. Given the 50%+ drop in crude prices from 2019 peaks, it seems reasonable to assume that jobs are at risk in the oil and gas extraction sector again. But even when you assume spillover into related sectors (oil and gas services, etc.), the numbers are relatively small when you consider there are over 105 million private non-supervisory employees on payrolls. Indeed, the oil shock of 2015 and 2016 is almost imperceptible on the overall unemployment rate. Likewise, energy CAPEX as a % of GDP is already relatively low, so the energy shock alone seems more important for financial markets than for energy CAPEX and GDP as a whole.
The line chart shows the number of production and non-supervisory employees by the thousands from 1980 through January 2020. It shows that the number has been increasing since 2016.
Distressed assets: The energy sector broadly was getting punished by markets even before this weekend. Energy is the largest weight in the high yield bond index, and low prices are clearly a negative. Energy high yield spreads have been widening since early 2019, and overall spreads are starting to follow. Given the recent decline in oil prices, it wouldn’t be surprising to see spreads near the levels we saw in early 2016, and to see defaults in the energy and energy-adjacent sectors pick up. This could present some tactical opportunities, but we believe the water is still too cold; it’s adult swim only.
The line chart shows two lines from 2010 through March 6, 2020: one showing energy high yield spreads and one showing spreads overall. It shows that energy high yield spreads have been widening since early 2019, and overall spreads are starting to follow.
Earnings: The energy sector is now only 3.5% of the S&P 500’s market cap (down from a 21st century peak of over 15%), and 4% of EPS (down from over 10% in the early 2010s). Over the last 12 months, the energy sector has lost almost 34% of its value versus the market, which is up (as of close on Friday) 7.25%. However, the energy sector still matters. Consensus was expecting the sector to contribute 5% of the index’s EPS growth in 2020. Now we should expect its earnings to decline. Our rule of thumb: If oil prices stay in the $30 per barrel range, that means we will have to knock down 2020 earnings per share expectations by another $3–$5.
Risk assets desperately needed some good news over the weekend, and they got the opposite. The big question on everyone’s minds is whether or not this will lead to a recession. At this point, markets are starting to say it’s already here. Treasury yields have never been lower, and markets expect the Fed funds rate to be back at zero by July. Last week, high yield and investment grade corporate credit default swaps had some of their worst weeks since the financial crisis, and the news over the weekend will likely exacerbate the move.
The S&P 500 is down over 18% from its all-time highs, and high yield spreads seem to be heading for their 2016 levels. Whether or not the NBER decides to declare that we experienced a recession is almost beside the point. What matters now is how long the global economy will have to deal with a severe shock from both the psychological damage caused by COVID-19 and the side-effects of stringent containment measures. The related decision by OPEC+ to abandon its supply agreement is just another wild card in a game where the rules change every hand.
Risks have increased, and we have made portfolios even more defensive in light of new developments. We are neutral weight equities for the first time in years. We have a full duration position, which benefits from falling rates. Most portfolios do not own directional high yield. Further, nothing about the COVID-19 shock causes us to lose conviction in our high-conviction growth megatrends: digital transformation, healthcare innovation, and sustainability. We believe those areas to drive growth for the next 5–10 years. This shock, even if it does cause a recession, does not change that view.
The volatility of the last few weeks has been relentless, and it seems unlikely that it will subside anytime soon. However, we build portfolios to capture only the amount of volatility necessary to achieve investors’ goals. Long-term investors should remember that periods of volatility and uncertainty are inextricably linked to long-term capital appreciation. This, too, shall pass.
All market and economic data as of March 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.
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