Storing up trouble beyond energy

The crash in oil prices is weighing more heavily on broader risk appetite as the battered energy sector endures further pain.

Not all equity markets are alike and with respect to energy, the more vulnerable benchmarks are those of Brazil, India, the UK and Canada, with weightings above one-tenth towards the sector.

MSCI Europe has an energy weighting of 4 per cent, with the emerging markets benchmark holding a 6 per cent share. The sustained pressure on crude spurred a 3 per cent drop for Europe’s Stoxx 600 as the basic resources sector slid 6 per cent. The FTSE 100, with its hefty resources exposure, fell 3 per cent.

In contrast, the energy weighting for the S&P 500 is less than 3 per cent and falls towards 1 per cent for the S&P 400 index of mid-caps and S&P 600 index of smaller companies. But Wall Street was not spared from a sharp bout of selling on Tuesday, and this perhaps reflects how the broad market has been cruising for a bruising of late given its strong rebound since late March. 

There is also the blowback from credit for Wall Street. The travails of the energy sector exert a stronger influence in the credit markets, now being supported by the Federal Reserve’s expanding balance sheet. 

DataTrek estimate:

“Corporate bond indices (investment grade and high yield) have more exposure to the group than any broad US, EAFE, or EM stock index.”

For example, the exchange trade fund for investment grade debt (LQD) has a 8.5 per cent weighting in energy, while the high-yield debt ETF (HYG) has a 8.6 per cent share. 

Both credit ETFs were under pressure on Tuesday, led by HYG, but they remain well above their lows of March, which of course marks the point when broader equity benchmarks began their bounce.

Analysts at Unigestion highlight how faith in long-term earnings growth rebounding next year has sustained the bounce in equities and credit off their recent nadirs. They note this scenario looms “if the current shock is temporary and followed by a strong recovery period” and add:

“Our analysis of credit markets is similar, as spreads are pricing a contained shock in 2020, but with a notable difference: spreads are supported by central banks, explaining our current preference for credit over equities.”

No matter the firepower of central banks, the oil price shock has repercussions, starting with a wave of energy bankruptcies that ripple back into the financial system. This will take time to emerge, hardly soothing broader risk sentiment, while the US dollar also has an ally from weaker oil prices upping the pressure on the currencies and sovereign debt of leading producers.

Tai Hui, chief Asia market strategist at JPMorgan Asset Management says:

“Low oil prices will also put pressure on commodity-exporting emerging markets, such as Russia, the Middle East and Latin America.”

Tightening global financial conditions via the oil crash tilt against the Federal Reserve’s efforts to weaken the reserve currency.

Analysts at Jefferies observe:

“The fact that the oil price drop contributed to the dollar doom loop will likely increase risk aversion within the financial system. It is set to cause a very deflationary backdrop requiring the central banks to be on the policy front foot in our view.”

Risk sentiment at some juncture will likely find solace in the prospect of greater official support, but there are nasty feedback loops brewing. And there is no sign of downward price pressure easing for “black gold” as the oil market runs out of places to store oil. 

For the first time in 18 years, Brent crude the international benchmark is below $20 a barrel and on Tuesday the price dipped below $18 ($17.51). The incoming front West Texas Intermediate futures contract (June) is following the path blazed by its predecessor, settling at $11.57, after trading below $7 a barrel during the session and down from a close above $20 a barrel on Monday. 

Marc Chandler at Bannockburn Global Forex believes “a significant imbalance of supply and demand will last a while” given how oil futures show prices below $35 a barrel through to October of next year. Marc adds:

“The collapse in the June contract warns that despite expectations of sharp drops in output (Opec+ agreement and market-forced) will not be sufficient to alleviate the storage shortage.”

Drawing up a list of winners versus losers from a historic rout in oil, Jefferies believes China is a happy camper “since it is the world’s largest energy importer — a rough rule of thumb is that a 0.5 per cent drop in oil imports to GDP is equivalent to a rise in 0.25 per cent in output”. 

India is another emerging economy whose trade balance will gain relief from weaker oil prices. 

TS Lombard’s Konstantinos Venetis argues that for all the current pain, a year from now, “do not be surprised if the market’s focus has shifted to upside oil price risks on the back of lower shale output, well productivity challenges, deficient capex and increasing M&A activity”. 

For the oil market, Konstantinos concludes:

“The playbook might be different, but the cycle will still play out.”

A year is a very long time for markets and plenty rides on production cuts accelerating and for the opening of economies that in turn bolster oil demand. Crunch time for global oil storage beckons as highlighted here via TS Lombard:

Over in the oil trading world, some are certainly happy and not yet ready to take the other side in spite of such a collapse. The FT’s David Sheppard writes that Pierre Andurand “has been betting against crude prices since early in the year” and he saw “little respite for the oil industry until a vaccine was discovered for coronavirus”. Mr Andurand’s rise in the ranks of savvy oil traders began in 2008 when he rode oil’s climb towards $150 a barrel and then cashed in on the subsequent descent. 

Quick Hits — What’s on the markets radar?

Finding ‘safe’ fixed-rate returns above 1 per cent is shrinking and Deutsche Bank’s George Saravelos poses the question: 

“If the US, Europe and Japan are stuck at zero forever, does it make sense that two of the most global growth sensitive countries — Korea and Czech — have yields above 1 per cent?”

George believes:

“A global liquidity trap means disinflationary forces will be so overwhelming that central banks that have resisted easing will have to cut more. And rich foreigners desperate for ‘safe’ yield will soon discover these bond markets — if you are Japanese why would you not pile into neighbouring Korea now that you have lost the US Treasury alternative?”

Hong Kong’s Monetary Authority was busy overnight, defending the currency peg with the US dollar (between HK$7.75 to HK$7.85), but at the stronger end of the band. Selling HK dollars into the market is the kind of intervention last seen in 2016. A stronger HK dollar of late has reflected a divergence between local and US interest rates, in the wake of recent Fed rate cuts. This has pushed the spread higher in favour of HK and may persist for some time says Brown Brothers Harriman. 

Source: Economy - ft.com