Oil and con­ta­gion

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

So much for the gen­tle year-end that looked to be in store after the swift re­cov­ery from Oc­to­ber’s sell-off.

In­vestors now face an acute dilemma as oil de­mand es­ti­mates get scaled back and the en­ergy com­plex howls: does the ef­fec­tive tax cut de­liv­ered to oil con­sumers out­weigh the ef­fects of cap­i­tal de­struc­tion and ris­ing bad debt that must re­sult from a 40% fall in prices? US eq­uity in­vestors have mostly cheered the on­set of $2 a gal­lon gaso­line and fo­cused on what looks like a gal­lop­ing eco­nomic re­cov­ery. But, while US eq­ui­ties were clearly primed for a pull-back, the blow-out in high yield spreads in re­cent days raises broader con­cerns about con­ta­gion.

At Gavekal, we are see­ing the end of a cap­i­tal in­vest­ment cy­cle that will still de­liver real pro­duc­tive uses. Yes, there will be credit con­se­quences from mal-in­vest­ment, but our broad call has been that the com­mod­ity down­turn, while a wrench­ing ex­pe­ri­ence for some emerg­ing mar­kets, is not a game changer for global growth. The main risk to that neat po­si­tion is a disor­derly un­wind in the en­ergy mar­kets. With the big economies still fac­ing acutely de­fla­tion­ary forces, as ev­i­denced by soft in­fla­tion ex­pec­ta­tions and high-grade bonds con­tin­ued stel­lar per­for­mance, the sys­tem is hardly well placed to deal with another cri­sis.

On this score, the ev­i­dence from the credit mar­kets is mixed. Stress in the high-yield space re­mains con­cen­trated in en­ergy. There has been a broad blow-out in spreads across the non-in­vest­ment grade spec­trum in re­cent trad­ing ses­sions, but not yet to wor­ry­ing lev­els. The US en­ergy sec­tor, which makes up about 20% of fixed in­come bench­marks, is cer­tainly pric­ing in sub­stan­tial de­faults, although to date there have not been sub­stan­tial bank­rupt­cies. That will surely come, but the real ques­tion is how big are the play­ers’ af­fected?

For a sin­gle sec­tor credit prob­lem to take on sys­temic proportions, it needs to threaten the banks. That was the sit­u­a­tion in 2007 and 2008 when a 5-10% fall in US real es­tate prices ef­fec­tively wiped out US bank cap­i­tal. This time around it is harder to iden­tify the weak hands hold­ing US en­ergy pa­per. Ob­vi­ous vic­tims are com­mod­ity-fo­cused hedge funds and a num­ber of those have closed their doors. How­ever, there is lit­tle ev­i­dence of con­cen­trated own­er­ship of US en­ergy pa­per within an iden­ti­fi­able set of fi­nan­cial in­sti­tu­tions. Out­side of the US, it is far more likely that the usual sus­pects among Euro­pean banks will be up to their necks in credit ad­vances to Rus­sian oli­garchs and other rel­a­tively high cost pro­duc­ers. As such, the con­tin­ued weak­ness across Europe makes a good deal of sense.

Should oil prices sta­bilise in the cur­rent range, global mar­kets could be look­ing at a “goldilocks” en­vi­ron­ment of mod­er­ately im­prov­ing growth and the good va­ri­ety of dis­in­fla­tion­ary pres­sure. As such, high-yield US en­ergy bonds could make for a plucky trade.

Last week’s risk-off re­ac­tion was sparked by an OPEC re­port pre­dict­ing lower oil de­mand. The big­ger con­cern for fi­nan­cial sta­bil­ity re­mains sup­ply re­sponses as Mid­dle East­ern pro­duc­ers were mov­ing the goal posts in re­sponse to the threat from shale pro­duc­ers by be­com­ing “mar­ginal cost pro­duc­ers”. In this sce­nario, prices go much lower, re­sult­ing in a large amount of global oil re­serves ef­fec­tively be­ing stranded. That re­mains an out­lier sce­nario, but each lurch down in the oil price raises the chance of an event or pol­icy mis­take spark­ing a cri­sis.

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