Oil price falls adds to stock markets pressures

Monday saw world stock markets fall by around 8% due to the combination of the still unknown economic impact of the growing Coronavirus pandemic and sudden heavy falls in the price of Brent crude oil.

Oil prices have plunged by 26% since last week. Together with recent declines, this means that the price of oil has more than halved since the beginning of the year. At the same time, a flight to the perceived safety of government bonds has pushed up bond prices, leading to the lowest yields ever seen on US Treasuries as a result of the inverse relationship between bond prices and their yields.

As a consequence of this double whammy, the already highly nervous stock markets have reacted with what can only be described as panic selling. After falls of around 5-6% in Asia, European stock markets open down by at least as much and in some cases more. Trading in US shares was briefly suspended after sharp falls led to an automatic halt in the selling and buying of stocks. Once trading resumed, the three major US stock indexes were down over 6%.
The S&P 500 index has lost 17% in value since 19th February while the FTSE 100 index is down 18.9% over the same time. Much of which is the result of automated stop loss trading.

Historically when markets have fallen 10%, a V shape recovery, as covered in our last blog, usually takes two – three months to recover. This has been the case with the majority of flu like epidemics, as warmer weather brings the virus spread to an end. This looks different now because along with the Coronavirus we also have an oil price war between OPEC countries and Russia which in turn will drag in the USA. Equity losses this year are now higher that 10% peak to trough which means that historically a full recovery in value has taken much longer to recover from.

Following the already significant declines in the oil price since the beginning of the year, there had been widespread expectations that OPEC and Russia would agree to production cuts to stabilise the oil price. It therefore came as a shock to oil traders and their positioning towards rising prices when the opposite outcome occurred over the weekend. Essentially, this means that Saudi Arabia and Russia opted for a resumption of a price war last seen in 2015/2016.

Saudi Arabia cut its oil price over the weekend after it failed to convince Russia to reduce production in order to stabilise the price of oil. Global oil supply is now far outstripping demand so the outcome of this fall out is a race for market share. This is a high-risk strategy that could have far wider implications. For Saudi Arabia a price war is risky. Even though it cost Saudi US$3 pb to extract oil it requires a price of US$82 to balance its budget. Russia can balance its budget at an oil price of US$40. The Russian Finance Minister Anton Siluanov said that ‘his country can withstand a low oil price for a decade’.
The consequences and potential tactic of this fall out is the impact a low oil price has on US shale gas and oil production.

It is quite possible that this strategy is also aimed at decimating the competition of US shale oil and gas producers, which require a higher oil price threshold than Saudi and Russia to remain profitable. Just as Trump pursued a strategy of ‘kick ‘em when they are down’ with China last year, it appears the same tactic is now being applied to US oil producers.

Given that the shale producer defaults and the resulting stress in credit markets caused an oil price induced stock market correction back in Q1 2016, it is not overly surprising that capital markets are following the same script now. It is possible that history repeats itself due to the double whammy of Coronavirus disruptions and oil market upset. However, the overall financial, political and economic environment is a different one compared to four years ago. A repeat of the oil price war tactics will no longer carry the same surprise factor and we can expect a much better-informed reaction by the US central bank and government to this renewed onslaught.

Back then, the biggest issue was that mass defaults across the US oil industry would increase the yield costs of corporate credit for all US businesses. Therefore, it is reasonable to expect the Fed will react very quickly to minimise this risk and use its immense quantitative easing (QE) firepower to sell US government and mortgage bond holdings and buy corporate credit to counter any selling pressures. This would also have the effect of easing any ‘flight to safety’ induced supply shortages within government bond markets.

What is more, neither commodity markets nor commodity producers are coming from bubble territory as they did four years ago. This time, there is unlikely to be a similar demand decline from resource industries for manufactured goods, which have already been forced to scale back expansion plans. On the other hand, a halving of the oil price, together with a significant reduction in the cost of borrowing, constitutes a significant stimulus for the global economy and in particular emerging markets, which will additionally benefit from an accompanying fall in the US$.

Certainly, as Coronavirus transcends Western Europe and North America over the weeks ahead, the slowing of economic activity and the resulting impact this will have could push weaker countries into recession and weaker companies fail. This will force central banks and governments to cut interest rates, increase liquidity and spend on emergency planning. Ultimately when the Coronavirus has passed, as it looks to be now doing in South Korea and China, that the world will have suffered lower growth and productivity that will need to be recovered with the assistance of lower interest rates and greater liquidity. If this is enough to create a catch-up bounce, we will have to wait and see.

We certainly expect some decisive actions from central banks. Such actions may now amount to The Fed swapping government bonds already on its balance sheets with direct purchases of corporate bonds, given that the big falls in government yields from the increased demand in bonds allows them to take supportive action without pushing up yield levels. The Fed has the means to put out this specific fear driven ’fire’, while the economic stimulus effect from the lower cost of energy and of capital should prove to be a very welcome relief over the coming months for the virus disrupted global economy.

Italy has now locked down its entire country in order to safeguard the public and try to contain the spread of Coronavirus. Italian Prime Minister Giuseppe Conte announced that the whole of Italy was now in lock down with public gatherings banned, schools and colleges closed and sport fixtures cancelled. This comes after Italy have suffered 9172 cases of Coronavirus and 463 deaths. If this strategy is taken up by other developed world governments, we can expect markets to worsen before they get better. Yesterday the UK confirmed 319 cases and 5 deaths with 25,000 people having been tested.

The experience of Italy will hit hard the country’s economy and this is likely to be repeated in many more European countries. What will be needed by governments is targeted assistance to help business deal with a short-term crisis and collapse in cash flow due to economic inactivity.
Wednesdays Budget is expected to focus on getting the country through the Coronavirus pandemic with support for sick pay and business cash flow. Other measures will be needed to pump the economy with investment in infrastructure, broadband, house building and transport links.

As you will know our portfolios are a blend of differing asset classes including cash, gilts, bonds and gold and will not have suffered the full impact of these market falls. In fact, many funds invested in gilts, bonds and gold will have a risen in this environment.

At the end of a tumultuous time for stock markets last week, the US stock market rallied hard into the close, leading to a slight weekly gain in those markets overall. This week may well prove similar as there are many more seasoned investors sitting on vast amounts of uninvested cash. Our overall view is to see this through but if income is being taken from investment that can be deferred then do so.

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