The huge six-year rally in global equities may be coming to an end, brought on by a drop in oil prices that has taken the value of the commodity to a low not seen in as many years.
First triggered by slowing demand from big emerging markets such as China during the second half of 2014 and an increase in energy production from the United States, the plunge accelerated in November when Opec, which controls 40 per cent of the world’s oil exports, refused to cut supply.
As a result, oil dropped 34 per cent in the last two months of the year. And since June, the price of oil has dropped by almost 60 per cent, joining a fall out that has also been denting the value of commodities including gold and wheat in the past couple of years.
To start with, it seemed the drop in crude prices would be a boon for consumers of energy, most notably at the petrol pump, with AAA, a US motoring association, estimating savings of US$75 billion for US drivers this year.
Yet it soon became clear the energy industry would suffer huge losses and that, coupled with the risk of deflation, would work more against global economic growth than for it – the very growth central bankers for the past six years have been trying to stimulate with low interest rates and bond buying.
The World Bank yesterday said the global economy resembles a train pulled by a single engine, the United States, with other regions dragging.
The Washington-based lender cut its 2015 forecast to 3 per cent from 3.4 per cent, reduced projections for the euro zone and Japan, and predicted a 2.9 per cent slump in Russia.
“Beware the Ides of March, or the Ides of any month in 2015 for that matter,” Bill Gross, a fund manager at Janus Capital, a US-based asset management firm, said in an investment outlook this month.
“When the year is done, there will be minus signs in front of returns for many asset classes. The good times are over.
“If real growth in most developed and highly levered economies cannot be normalised with monetary policy at the zero bound, then investors will ultimately seek alternative havens,” said Mr Gross, better known in his previous role as the chief investment officer of Pimco, which manages the world’s largest bond fund.
“Not immediately but at the margin, credit and assets are exchanged for figurative and sometimes literal money in a mattress.”
What began as a fall out in the stocks markets of oil producers such as the UAE, Nigeria and Russia and then extended to the junk bond market now looks like it may trigger a wave of selling across global markets this year. Already the S&P500, the benchmark measure of US listed companies, has declined 1.5 per cent this year while the MSCI ACWI index, a measure of global stocks in both emerging and developed markets, has dropped 1.7 per cent.
Since 2009, the S&P 500 index has gained 125 per cent while the MSCI ACWI Index jumped 80 per cent. With the indexes trading at hefty price to earnings ratio of 17.95 and 16.6 respectively, the chorus of bears –those who think stock prices will fall – is getting louder.
“It’s not a time to be getting nervous but it’s a time to be going through the good old rule of preservation of capital being the number one thing you need to do as an investor,” says Steen Jakobsen, the chief economist at Saxo Bank, a Danish investment bank.
“You need to protect your great run in stocks and the way to do that is to reduce your exposure to where it was in 2008/9 when it was low. You’ve had a 100 per cent return since then, now is the time to take some money off the table is not bad.”
At the heart of the problem is that on the whole disinflation (falling prices), and outright deflation (an inflation rate of below zero), will mean a rise in real interest rates which will make it more expensive to service debt, increasing the burden of over-indebted nations such as the US and the United Kingdom and potentially triggering another debt crisis.
The US is the most indebted country in the world, with more than $18 trillion in public debt and a debt to GDP ratio of above 100 per cent.
“The big story next year is not the Fed exit, the ECB [European Central Bank] adopting QE [quantitative easing] , China’s hard or soft landing or Abenomics,” Ethan Harris, a global economist at Bank of America Merrill Lynch, wrote in a research note to clients on November 23.
“These are all derivatives of a deeper story: global disinflation. In the US it is low inflation that allows a slow-motion exit from super-easy Fed policy. In Europe, it is the threat of deflation that forces the ECB to steadily expand its balance sheet, and it is deflation that could trigger another debt crisis.”
But oil will remain part of the story for the foreseeable future as Opec attempts to put shale oil and gas hydraulic fracturers – or frackers as they are known – in the US out of business by making it unprofitable for them to produce at the current price per barrel. Brent, a benchmark for crude, is currently trading at about $44 a barrel from more than $100 in June.
As a result of that drop, it is not just frackers who are feeling the pain but energy companies as a whole are beginning to suffer as a sell-off in their stocks testifies. In turn, those divestments are being extended to the junk bond market in which energy companies account for a sizeable proportion of debt. On top of that, there is also concern that some emerging market countries such as Venezuela and Russia, which rely heavily on oil, may be forced to default on debt.
However, as with deflation, the main concern is that declining profits at energy companies will hurt the global economy as bankruptcies and failure to pay back debts beckon and spill over into other industries. In the US, the energy industry accounts for 0.5 to 0.75 percentage points of GDP growth, according estimates.
Already, forecasts for first-quarter profits in the Standard & Poor’s 500 Index have fallen by 6.4 percentage points from three months ago, the biggest decrease since 2009, according to more than 6,000 analyst estimates compiled by Bloomberg. Reductions spread across nine of 10 industry groups and energy companies saw the biggest cut.
“I think oil is everything,” says Mr Steen. “One thing I’ve learned in 30 years is that energy is everything. In 2008, when the oil price rose to $160 a barrel, it took out $5tn of consumer demand and that was essentially, in my opinion, what caused the euro crisis because those countries couldn’t afford it any more. Now the drop in oil prices is certainly hurting the US.”
Still, not all world’s 100 or so main equity indexes are likely to move in the same direction, nor are the thousands of stocks they include, so the enterprising investor should be able to find opportunities if he looks hard enough.
Mr Steen says miners are attractive given the turmoil they have been contending with as commodity prices collapse.
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