Wellian Weekly 23.03.2020

Complacency?

Last week a long-term client got in touch after reading the last piece we put out (https://www.wellian-is.com/53/572/wellian-weekly-16032020) questioning whether it was maybe a bit complacent in relation to what has been happening in the capital markets over the last couple of weeks.

My initial response was “no, I didn’t think we were”. After all, we had written about the Coronavirus for the past two weeks - here (https://www.wellian-is.com/53/318/wellian-weekly-09-03-2020) and here (https://www.wellian-is.com/53/568/wellian-weekly-02032020) but maybe, in retrospect, we should have written again. So, for the third week in four, here goes.

Thinking about the financial events of the week 9th March to 16th March, maybe my initial response was wrong. Maybe the Wellian Weekly should have focused on the events that shook the financial world in such a short period of time. (When I say “maybe” I was wrong, I actually mean “absolutely”)

In that week…

  • The US cut interest rates by 1.00% to practically zero.
  • $700bn of Treasuries and MBS would be bought back
  • $1.5trn of short-term funding was promised to shore up the markets and keep liquidity present.
  • The Bank of England cut interest rates to 0.25% from 0.75%.
  • OPEC+ had a very visible disagreement with the price of oil falling by over a quarter
  • (…as a light-hearted aside, I was amused to find out at one stage last week that the cost of physically buying a barrel cost more than the oil that went inside)
  • Economies across the world revised down GDP forecasts for this year
  • The S&P circuit breakers kicked in for the third time in as many weeks to calm nerves
  • The Bank of Japan announced an increase in asset purchases…

Equity markets hit free fall, the US 10Y Treasury yield sunk below 1% and there was both discriminate and indiscriminate selling of pretty much any asset.

Was the sell-off due to the fact coronavirus was becoming a global issue? Or was the fact that Coronavirus was becoming a global issue the final straw that broke the camel’s back with regard to global equity valuations? Was it something else?

It is very obvious that we live in a global environment and the outbreak of the Coronavirus has severely tested supply chains. Who’d have thought that issues in a city in China called Wuhan (hands up if you had known of the city before December) could have been and felt all over the world and in such a short amount of time? Ships that cannot dock for days / weeks at a time will cause backlogs and pinchpoints. Just-In-Time manufacturing is brilliant if there are no delays. In the light of this, companies will have to review their distribution networks, how they do business and many other factors.

In among the headlines of “thousands of new cases identified today” and “epidemic turns to pandemic” and “rush to buy toilet rolls” which are both newsworthy and fear inducing, one area that I don’t think has had the amount of column inches that it probably should have is the collapse in the oil price and the impact it could have on the global financial system. This is the main reason, I believe, why the market has reacted in the way it has.

Many will see a lower oil price as a boost to the economy. Oil is the lubrication that makes the world work – it is used to make things, used to make things into things (plastic for instance). It is the fuel for power and transport for instance. After all, a lower oil price equals lower input costs and higher profits! For countries that import oil a lower cost is a boon. But, it is a huge tax revenue generator for governments. Many listed oil businesses pay huge dividends to their shareholders and that circulates around the markets as well as the real economy.  With a lower oil price, will BP and Shell (both on double digit dividend yields) be able to maintain dividends being as the cost of the natural resource they extract has fallen as dramatically and as quickly as it has?

But this isn’t the angle I’m thinking of. I’m thinking initially of the US High Yield Bond Market. Companies in this index are below investment grade. They have to pay more in interest to raise finance. Their balance sheet isn’t as strong by default.  Lots of companies in this index are involved in the oil industry – with many of this subset being involved in the Fracking industry.  For a good few years, the fracking industry has been the marginal decider of the price of oil.  When oil price rose (usually due to OPEC choking supply) fracking would step in, flood the market and a lower price would emerge. Fracking has become very efficient, and quick and easy to turn supply on and off. But, fracking still has a minimum price for it to be profitable. This price is much higher than Saudi Arabia or Russia can extract the oil for, so with the oil price falling as it has done, the knock on effects could be huge….

  • Fracking businesses cannot operate at sub $30 oil
  • Fracking businesses fail to pay interest to the owners of the debt
  • Fracking businesses default and go bust
  • There is a run on the high yield debt market as investors rush for safety
  • The contagion effect runs into the investment grade market
  • Fear of the investment grade market struggling feeds into the equity market and other capital markets this exacerbating the current situation.

Coronavirus will definitely slow global demand and thus GDP and will impact capital market valuations, but I think the impact of the rapid decline in the oil price reaching these lows is what has really spooked the markets. OPEC+ does not have the same predictability on monitoring the oil price as OPEC did. It has now become a much greater tool in political gain for these countries. It places another hurdle in the way for companies and countries in volatile times. It will make planning and forecasting harder to achieve. It will make capital markets less easy to understand. Coronavirus has followed a predictable pattern and if managed correctly will have a slowing impact on global growth. A variable oil price will have a much greater impact…

I hope this piece goes to show we are not being complacent with our views and that we do think more than just of the short-term when it comes to investing. It’s great to have feedback from our readership and clients. Thanks for your ongoing support; it is very much appreciated.

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