We take no solace in the first-quarter bounce in energy prices, as historical examples show that oil price collapses are followed by persistent market volatility.
An uptick in defaults among lower-rated, commodity-price-sensitive companies is less of a cause for concern than deteriorating overall credit conditions for the broader economy.
While we believe a U.S. recession is not at hand, corporate earnings are in recession, as profit growth has stalled due to the strong dollar and weak commodity prices.
The stock and bond markets tell different storiesMarkets took investors on another rollercoaster ride in the first quarter. After a multi-year period in which the U.S. equity market advanced without a pullback of more than 10%, we have now experienced two significant corrections in the span of seven months, with an 11% drop in August 2015 and a 12% plunge in January.
And just like last summer, as we begin the second quarter, volatility has subsided and prices have risen. The implied volatility of the S&P 500 Index tracked by the VIX — the CBOE’s Volatility Index — is already back below 14 after reaching well into the 20’s for much of the past two quarters, and as high as 53 in August. Short-term realized price volatility of equity indexes also fell to quite low levels at the end of the first quarter, which underscores the movement in implied volatility. By the end of March, 10-day annualized price volatility for the S&P 500 had dropped as low as 6.5%. Daily price moves were less than 1% for 13 consecutive trading sessions.
What explains this sudden calm in markets after a second tumultuous period? Certainly a major contributor to the subdued mood was the Fed’s decision in its March policy meeting to signal only two increases to the target for the federal funds rate in 2016, compared with its previous intention of four increases. The Fed thus reduced the estimate of the policy rate at the end of this year by 50 basis points, a shift that largely paralleled other dovish rhetoric and stimulative actions by other major central banks around the globe.
Nevertheless, despite the more positive sentiment for risky assets that prevailed in March, we are still not yet prepared to silence the note of caution that we sounded at the start of the year. We think it is somewhat telling that the positive sentiment that lifted equities in March was not confirmed by the bond market. The yields on 10-year U.S. Treasuries fell along with stock prices from 2.3% at the end of 2015 to 1.7% in mid-February when the S&P 500 touched 1829. However, even as the equity market then rallied 13% into the end of the quarter, yields barely moved, closing at 1.77% at the end of March — a sign of persistent risk aversion.
Energy weakness spreads across risk assetsWe are also concerned that the correlation between oil prices, high-yield securities, and equities remains quite elevated. The rally in oil prices from about $24 per barrel back to $40 has given hope to some commodity-related companies that were facing almost certain bankruptcy had the price of oil stayed below $30. But the oil price rally has masked continued deterioration in the fundamentals underlying the credit market. Even outside of the energy sector, the amount of leverage on corporate balance sheets continues to rise and cash continues to fall.
We take no solace in the bounce in energy prices. We examined previous instances of violent collapse in the price of oil and found that markets subsequently move sideways for extended periods while experiencing extraordinarily high volatility. This condition is evident in the late 1980s and during most of the 1990s, when price swings of well over 30% in both directions were the norm and not the exception. Underneath today’s apparent calm, the options market is telling the same story as these historical examples, as implied volatility remains higher than at any time in the past four years. Even if oil prices stay near $40 per barrel, it may be too little, too late for many of these companies. Energy companies undergo a periodic financing process with their banks to determine what is referred to as their “borrowing base.” Essentially, the banks, every spring, estimate the value of the company’s assets to determine how much they are willing to lend via direct loans, lines of credit, and letters of credit. Early indications of the spring 2016 asset assessment for a handful of energy companies mark down borrowing bases by an average of 20%. Since free cash flow from operations has collapsed for many of these companies, the ability to refinance as bonds mature and loans come due will be critical to their survival. With a significant impairment of the asset side of their balance sheet, some of these companies may not live to fight another day.
Weaker credit creation may restrain growthAs we have written previously, our chief concern is not merely the ultimate default rate for these commodity-price-sensitive, lower-rated companies. Of much greater concern is the overall financing environment for the broader economy. We have already seen a marked deterioration in the availability of credit for all lower-rated companies. This is, we believe, a lagged effect of the stress that began as a more limited consequence of the widening of yield spreads on energy sector debt in mid-2015.
High-yield issuance in early 2016 is the lowest we have seen since the first quarter of 2009, in the depths of the financial crisis. Remember that U.S. corporations tend to be financed mostly via the capital markets rather than banks. In Europe, where companies tend to rely more on bank financing, the news is no better. The equity prices of European banks have declined by more than 30% since August 2015, underperforming the overall European equity market by almost 20%. In addition, the cost to insure against default for a group of European banks has more than doubled in the past year. It’s a troubling development given that new credit creation was starting in Europe, and this evidence calls into question the willingness and ability of the banking system to continue to lend to the corporate sector.
It is also curious that the Fed felt the need to roll back two implied rate hikes this year, in the face of continued strength in the labor market and a good bit of evidence that inflation is behaving as the Fed expected — rising toward its 2% target. The mention of “global concerns” has been prominent in Janet Yellen’s recent speeches, yet this trend is contrary to the data coming out of China, which has not deteriorated since the Fed’s December meeting, when the process of rate normalization started. It is possible that the emerging-market debt overhang, rather than China, is weighing on the minds of Fed policymakers. While the pause in the appreciation of the U.S. dollar has taken focus off the EM debt issue, it is clearly a problem that has not gone away.
In addition, as the United Kingdom prepares for its June referendum on leaving the European Union, the economic issues that an exit could create are an additional source of uncertainty. The bombings in Brussels and the continued debate on how to handle the influx of refugees displaced by the civil war in Syria have added to the premium that should be demanded for geopolitical risk. Earnings reports for the first quarter will contain valuable information on just how much damage to the corporate sec-tor has been done by the volatility that first flared in the summer of 2015. We continue to advocate running portfolios at reduced levels of risk, and we remain somewhat cautious on risky assets.