We thought Monday’s sharp equity market falls, due to the plunge in oil prices and deteriorating Coronavirus situation, are worthy of an update.
As you will no doubt have read, OPEC, led by Saudi Arabia, had been pressing Russia to cut oil supply, to firm up prices. Russia would not agree to this, leading to Riyadh retaliating by increasing supply and cutting prices further in a bid to increase their market share.
The last oil slump in 2014, based on similar strategy, quickly turned a current account surplus to a $98bn deficit a year later. Hundreds of projects were halted and tens of billions of dollars owed to contractors went unpaid, leading Riyadh to eventually cut a deal with Moscow in what became an OPEC+ alliance. With Saudi’s $300bn of reserves and Russia’s $150bn national wealth fund (9.2% of GDP), this could be a long stare-out; Russia suggests its reserves can last for 6 to 10 years with oil at $25-$30 a barrel. Therefore enormous strain on the economies and public finances of oil-producing nations (predominantly emerging markets) should be expected.
The slumping oil price has quickly translated into significant stress for oil distributors and producers, where those highest marginal cost producers, such as US shale firms, risk falling into bankruptcy.
Normally falling oil prices result in a direct transfer of wealth from Russian and Saudi current accounts to consumers in the form of lower industrial energy input costs and increased domestic disposable income, via lower prices at the pumps and home fuel bills. The European Central Bank’s rule of thumb is that every €10 fall in the oil price leads to 0.3% GDP growth within 2 months.
However, lower energy costs only aid economic growth where consumers rush out to spend their windfall. With the coronavirus threatening us all with lower levels of activity, oil dependent nations may see little economic benefit this time round in the short term, even if the consequential household savings and pent up demand is released in the future.
Whilst the virus epidemic in China appears to be past its peak, and Singapore and Taiwan have shown it is possible to contain the virus without resorting to China’s extreme tactics, realistically it is not likely that the US or other western countries will emulate them. Asian nations appear to have a higher social control alongside centralised public health systems. The headline case numbers, in the US and in other countries, will probably get a lot worse between now and the end of March. Exactly how fast and how much longer the virus keeps spreading after that will depend on many factors such as the public health response and whether or not the rate of infection will slow in warmer weather.
Whilst Italy has put the entire country under quarantine, this is still not as drastic as in China. Italians are still permitted to leave their homes and go to work, as well as buy food and supplies, but schools, cinemas, theatres, museums and bars are closed, sporting events cancelled and the numbers frequenting restaurants and shops limited. Other nations will be watching to see how successful this softer approach is, in the hope of reducing the potential economic impact.
The extreme market reaction of the last few days demonstrates the worry that, to bring the virus under control, the US and Europe may need to shut down far more economic activity than is currently the case (i.e. to adopt the more extreme measures China deployed) and that monetary and fiscal stimulus may be ineffective in helping as virus-hit economies neither lack the supply nor demand, but simply the physical ability to bring the two together under such potential constraints.
Nevertheless, some easing of financial conditions may help at the margin, in particular in sustaining those barely profitable companies existing only due to cheap debt. Whilst the US has responded with a sharp decrease in interest rates, the ECB has little room to do so and we look forward to their announcement of measures on Thursday. Even so, ahead of us there is a significant risk of increased corporate stress and rising unemployment.
So, in summary, this is a fast moving situation where unpredictable new news of the virus’s spread and consequential centralised intervention measures could send stock and bond markets swiftly in either direction. We remain of the opinion of not trying to trade in such volatile markets – being encouraged that Chinese equity markets have been quite robust following the slowdown in infection rates – but of gradually putting surplus cash to work now given a long-term view. Such times also demonstrate the value of our diversified portfolios with our gold and hedge fund positions providing valuable risk mitigation, taking the sting out of the equity market falls.