Equity Market Update
With this morning’s decline, equity markets as measured by the S&P 500, have corrected approximately 19% off their recent highs. Investors have added another item to their current “wall of worry” and that is a sharp decline in oil prices. Added to COVID-19 virus concerns, election uncertainty and a flight to safety that is sending bond yields to historically low levels, it is easy to see why investors might be overcome with emotion right now about the future value of their investments. We remind investors that the long-term value of their equity investments is derived from years, if not decades, worth of earnings power and not just the outlook for the next few quarters. Moreover, while extremely uncomfortable, market corrections are normal and, just as important, are temporary in nature. For example, according to Guggenheim Partners, since 1945 there have been 80 declines in the S&P 500 of 5-10%, 29 declines of 10-20% and eight of 20-40%. Respectively, they took one month, four months and 15 months to recover from, but recover they did.
Eventually the cycle of fear turns to a cycle of greed where shorter-term holders are replaced by longer-term investors who smell a bargain because they recognize the long-term value creator that equities represent. Bottoming processes are messy and pinpointing the exact moment when fear turns to greed is a challenge. It usually happens at the intersection of compressed valuations, uncompelling alternatives, investor capitulation and even, in some cases, recession. Then the upward cycle can begin anew. To get comfortable that real long-term value exists in the assets we hold, we often must familiarize ourselves with the “wall of worry” issues themselves and take them into consideration within the context of our overall portfolio. So today, we take a closer look at the cause and impact of the oil price sell off as well as update you on the current bond market and what it could be signaling.
Oil Market Update
Tensions between Saudi Arabia (OPEC Member) and Russia (non-OPEC Member) have been brewing for several weeks as the spread of COVID-19 continued to cut into crude oil demand, which finally came to a head this weekend. The spread of COVID-19 is estimated to have cut Asian energy demand by 1.5-2mb/d. Due to the loss of demand, Saudi Arabia wanted to push through an additional 1.5mb/d supply cut on top of the already 2.1mb/d supply cut that is set to expire at the end of this month. In order to achieve the proposed 1.5mb/d cut, OPEC needed non-OPEC members, Russia in particular, to agree to the additional cuts.
Russia refused to concede to Saudi Arabia’s demand, which meant that not only was the additional 1.5mb/d cut not going to happen, but also that the current 2.1mb/d cut would expire at the end of this month, allowing OPEC and non-OPEC members to pump at will. According to sources at the meeting, Russia’s energy minister said they would refuse the additional cuts because the U.S. has been taking advantage of OPEC and non-OPEC members by continuing to produce record amounts of crude. Russia wanted to use this opportunity to send a signal to U.S. producers.
Following the breakdown in talks with Russia, Saudi Arabia, in an unprecedented move, engaged in an all-out oil pricing war sending global energy markets spiraling down 20-30% on the reopening Sunday evening. Saudi Arabia announced it would lower its prices for April delivery to Asia by $4-$6 a barrel and to the U.S. by $7 a barrel. According to several sources, they also said that when the current production cut expires at the end of this month, they might increase production to 12mb/d, up from its current rate of 9.7mb/d.
WTI crude oil fell to a low of $27.43/barrel, a level not seen since early 2016 and, prior to that, 2003. Brent crude oil fell to a low of $31.02, the lowest levels since 2016 and 2004 prior to that. Refined products also kept pace with the decline in crude oil with gasoline and heating oil both falling over $0.20 cents per gallon to lows of $1.0574/gallon and $1.0799/gallon, respectively. Also, to put last night’s action into perspective, second month crude oil volatility spiked to over 100%, a historic high.
Commodities, by their very nature, are self-correcting. Lower prices curtail production, which plants the seeds for recovery in the supply and demand equilibrium. Furthermore, lower prices for oil and its byproducts, while painful for producers, can be a boon for consumers as input costs for manufacturing decline and refined products like gasoline create direct savings at the fuel pump, which can be redirected elsewhere in the economy.
Fixed Income Market Update
Volatility across the fixed income markets has increased significantly over the past two weeks. In a flight to safety, Treasury yields have hit all-time lows nearly every day over the past seven trading days. The 2-year Treasury note yield is at 0.33%, the 10-year Treasury is 0.53% and the 30-year Treasury is at 0.98%. Credit spreads have gapped wider today as liquidity in the credit markets is finally starting to show signs of strain. Investment grade credit spreads are 30-40 basis points wider today and bid/offer spreads have gapped wider to at least 10 basis points on most credits. High yield spreads are about 140-150 basis points wider today and bid/offer spreads are in the 5-10 point area. Much of the high yield gap can be attributed to the energy markets because small cap energy companies are a frequent issuer of high yield debt.
The Fed is now being forced to act even further. Expectations are that the FOMC will cut interest rates at least 50 basis points, possibly 75 basis points at its March 18th meeting, if not sooner. We believe the Fed will also take additional measures to help shore up liquidity in the markets. While nothing has been said of what they will do, some actions include purchasing corporate bonds in the open market and possibly implementing a relief-type program for small and middle-market companies who have been hit hard by COVID-19 virus interruptions and frequently have a lower margin of safety for slowdowns. We believe all manner of response will be on the table for the Fed.
While yields on bonds are significantly lower, fixed income remains an important piece of diversification in portfolios. Year-to-date, the Bloomberg Barclays Aggregate Index has returned 5.87%, helping to offset some losses within portfolios from the equity markets. Despite the low yields, we believe fixed income can continue to be held as a hedge against additional equity market volatility.
As you review your portfolio, we encourage you to assess your response options in the context of your time horizon, current asset allocation and the quality of assets held in your portfolio. If these foundational objectives are present and match your personal circumstances such that you can remain focused on the long-term, then the probability of emerging from the current market correction unscathed, are solidly in your favor.
If we can answer any questions for you about your portfolio or the current market environment, please do not hesitate to contact us.