March 9, 2020
As you are undoubtedly aware, the markets have been increasingly volatile over the past two weeks due to concerns about the potential economic impact of the coronavirus, reactions to the outcome of Democratic Primary on Super Tuesday, and, most recently, the negative outlook for oil prices.
The net result has been a significant pullback in global equity prices. While we are concerned about the overall short-term outlook in the markets, we hope to use this decline to identify attractive investments while also seeking to protect client assets within longer-term investment strategies.
In terms of the recent oil price movement, yesterday Saudi Arabia launched a price war after OPEC failed to agree on production cuts at an extraordinary meeting in Vienna last week. This action appears to be directed at Russia after it failed to unite with the cartel’s attempt at supporting crude prices weakened by the expected economic impact of COVID-19. The Kingdom plans to increase production to more than 10 billion barrels per day when the existing deal ends next month. It also offered its important customers a significant discount on the oil it produces in an attempt to maintain market share.
News of the plan caused energy prices to decline more than 20% – the largest drop since 1991. When the U.S. market opened this morning, New York Stock Exchange “circuit breakers” triggered when the S&P 500 fell 7% during the opening minutes of trading. The index ultimately ended the day off 7.6%.
The Japanese Nikkei-225 and Australian S&P/ASX 200 indices were down more than 5% and 7%, respectively. The Euro Stoxx 50 index fell more than 8%.
Markets are broadly in “risk-off” mode as the entire U.S. Treasury curve is trading below 1% for the first time. Gold is higher and heavy selling has hit the dollar. To ensure adequate liquidity for money market funds, the Federal Reserve announced a 50% increase to at least $150 billion in its overnight repo program through Thursday and also more than doubled two-week term repo to at least $45 billion.
Given these many factors, a few important things to remember include:
- We should brace ourselves for a period of extreme volatility as investors sort out the impact of the coronavirus on economic activity and the collateral damage that an oil price war could inflict on the U.S. energy industry.
- The Saudi move is not a new one. They launched a similar effort in 2014 to impose price discipline on the market in the face of rising U.S. shale production. It appears the Kingdom cannot afford to engage in a prolonged action, as their government finances will not support it. It is generally believed they need crude prices to be somewhere between $80-$85 per barrel to balance their budget.
- This action will cause dislocation in the high-yield market. At a weighting of roughly 11% of the high-yield market, energy bonds have a material impact on this sector. Already a number of high-yield energy issues are trading at distressed prices. We continue to recommend a zero weight to high-yield bonds based on our long-standing concerns about the underwriting standards used in this sector of the fixed income complex. This is potentially a manifestation of those fears.
- We will likely hear calls for more interest rate cuts from the Federal Reserve and demands for a fiscal stimulus to support confidence and encourage consumption. This could help counter the commercial disruption from the epidemic and the collateral damage of an oil price war. The Federal Funds futures market is currently pricing three to four rate cuts over the remainder of this year.
- What is now unfolding is a demand shock (i.e. postponement of purchases) and not a financial shock like 2008, though it may feel like one. If consumption declines materially as epidemic-related mitigation efforts unfold, corporate profits could see significant, albeit temporary, declines.
- Consequently, markets will need time to consolidate around the recent lows. Indeed, large companies may follow their small cap brethren into bear market territory as uncertainty roils markets.
- We recommend refraining from buying in the dip at this point. We will likely see a number of bankruptcies in the energy sector and we could see distress in other sectors where credit underwriting was weak. A negative U.S. GDP report in Q2 is a real possibility.
- We are continuously searching for new opportunities that this selloff creates and are actively working on multiple ideas and themes to execute at the appropriate time.
As always, we will keep you informed of important developments and encourage you to reach out to your Investment Officer if you have any questions or concerns.