Market Perspective for 12.16.14
It seems like each update starts with how much the market has changed direction from the previous update. As this is written, the stock market has completed a horrible week as investors contemplate what the drastic decline in oil prices portends. (See Figure 1) CNBC wants us to think of this as a great blessing as lower gasoline prices will have a positive effect on consumer wallets. In time, they are possibly correct. In the short run, however, we are concerned about two things: one, what this says about the world economy in that global energy demand continues to decelerate; and two, what will this mean to those countries, companies, and traders whose “portfolios” were geared to much higher oil prices. Can Russia, Venezuela, and other oil producing countries survive economically if this continues for another year? What damage will be done to Iran or Brazil? Beyond this, what banks might be on the wrong side of hedge contracts at $90 per barrel? What global macro fund bought weakness in oil prices as it slid to $75, then $70, $65, and recently under $60? What might they have to sell to meet margin requirements? Rapid price changes in heavily traded commodities throw a certain degree of chaos into markets even if on balance they are positive to most participants.
Figure 1
Source: Stockcharts.com
The other concern is that this is coming at a time when global economies were also adjusting to the sharp rise in the dollar. This was playing out largely in emerging markets, where there has been capital flight this year since the carry (borrowing the dollar to invest in higher yielding currencies) trade is being rapidly unwound. As local currencies decline relative to the dollar, the price of imported goods rises and this inflation erodes living standards. Political instability is the result, and it often arises without much warning.
Europe should also be on investors’ concern list. Greece has recently seen a sharp decline in its stock market. Europe has a currency problem of a different sort – the Euro has risen against most world currencies (just not the dollar). This is making their products less competitive at a time when they desperately need to export. Germany, as Europe’s largest exporter, is the country being affected the most. Germans would be probably less able and willing to step in and help the Greeks if it came to that.
Corporate Bonds
By now it is apparent that the sell-off in oil has also had an impact on the corporate bond market. High yield bonds have been pounded as investors note that approximately 15% of U.S. junk bond debt[1] is energy related. Firms have borrowed heavily to develop shale gas plays from the Bakken in North Dakota to the Marcellus in the Appalachians down to the Haynesville and Permian formations in Arkansas and Texas. Some firms may not be in a position to cut production even if it is below breakeven because they need to service this debt. This debt sell-off has been a huge wake up call to many investment advisors – in a deflationary environment only high quality debt provides diversification. A five-year treasury note, even at 1.55%, is going to perform much better than a 6.25% five-year bond from a CCC-rated energy exploration and production company. On the whole, says Societe Generale’s Albert Edwards, U.S. corporate balance sheets are much worse than you would expect given the absurdly low borrowing rates of the past several years. Why? Corporations did shore up their finances between 2009 and 2011 as the economic outlook was cloudy. Over the past three years, however, they went on a borrowing spree in order to finance stock buybacks that would boost their earnings per share (EPS). The result is higher stock prices than fundamentals warrant because EPS is artificially inflated and because more leveraged balance sheets merit lower P/E (stock price to earnings) ratios.
Santa Claus Rally?
Normally as year-end approaches investors buy companies and industries that have done well on the year, hoping to capitalize on the momentum effect (which is typically strongest at the end of the year). This year there seems to be a trend of selling more volatile securities not likely to bounce back before year-end. It may be worthwhile for patient investors to consider the energy, mining, and machinery sectors that have been hit the hardest this year. I do not expect any kind of a fast economic recovery in these sectors, but all it would likely take is a sentiment change, say from loathing to indifference, to give their stock prices a boost.
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