Market comment - Oil price shock causing new market sell-off

News item -

This weekend, financial markets came under serious pressure again. Not only developments regarding the coronavirus, but also the plunge in the oil price after the unexpected breakdown of the OPEC+ discussion battered markets across the board.

Market sentiment is starting to deteriorate quite significantly, as illustrated by the high level of volatility. Investors are wondering what could be the impact of such level of uncertainty on the global economic outlook. We think, however, that the oil price collapse is temporary.

Energy big part of US high yield

Within fixed income, especially the US high yield segment was hit by the coronavirus and the oil price shocks. Relatively tight spread levels on high yield bonds make the asset class vulnerable to economic disappointments in an end-of-cycle environment. Also, energy is approximately 7% part of US high yield. We currently maintain an underweight position in global high yield (70% US) versus emerging markets debt.

Of course, the oil price plunge has struck the US energy sector. The spread (risk premium) on the US energy sector widened the most, once the coronavirus started to impact global economy and demand for oil. The spread widening made the price drop, as bond yields and prices move in opposite direction. We expect the sector to significantly underperform further, now that the oil price has collapsed. Although the energy sector restructured itself after the oil price collapse in 2015/2016, it still needs a relatively high oil price to sustainably generate a profit and deal with high debt levels.

Oil price collapse temporary

The sector needs an oil price level of USD 50/bbl to stay in business. Most oil producing companies have, however, set up oil-price hedges for the year, so they should be able to withstand some short-term volatility. But as these hedges will run off, this will leave them exposed, especially with many debt maturities coming up as of next year. As such, the sector is now at a significant risk for increasing default rates.

Notwithstanding these risks, we will not sell our position in high yield further. In terms of pricing, most of the damage will be done before any trading is possible, also due to illiquidity in the high yield market. At the same time, we regard the current oil sell-off as temporary, as we expect that Saudi Arabia is only trying to bring Russia back to the negotiation table (and is not targeting US shale oil producers). If successful, this could result in oil prices rebounding to better levels, as soon as the oil market will be balanced again.

Energy sector hit

Within equity markets, the most recent market weakness focused on the energy sector, with oil-related companies potentially having to cope with substantially lower oil prices. This would directly bite into profit margins. In addition, the sector financials came under pressure. On the one hand, due to declining long-term interest rates that will put pressure on net interest margins and on the other hand, due to the level of provisions related to the energy sector that might start to increase.

At the same time, the sectors utilities, consumer staples and health care are behaving as relative safe havens. At regional level, European equity markets are underperforming due to the turbulence in Italian equity markets. Emerging markets are outperforming, in particular China, where the peak of the virus has been reached.

What should investors do?

We hold on to our asset allocation for the time being, as we think this is not the right moment to make changes in the portfolio, with the current high levels of market volatility. We continue to monitor markets closely and keep you up to date via these Market Comments.

Richard de Groot
Global Head of Investment Centre