Happy Annus Horribilis?

Happy Annus Horribilis?

Posted on 9 January 2015
"How could the mood turn so dark when just weeks before, global equities were in the midst of an impressive rally?"
To describe the start of the year as inauspicious is a bit of sublime understatement. The mood of investors globally was dour, and their actions could be best characterised as risk-averse. Furthermore, the picture of equity markets in the Americas, Europe, and Asia was that of a sea of near-perfect red.[1] In a quasi-symmetry of action, the shunning of equities was offset by the embracing of Treasuries, Gold and Silver. “Risk off” was the prevailing strategy of the opening days of 2015. The catalysts for the “black dog” hanging over markets were the usual, recycled reasons: an existential threat to the euro zone project by a Greek exit from the currency bloc; plunging oil prices that portended a global economic slowdown; and the attendant threat of global deflation. Any one of the above threats could cause a market swoon; combine the lot, and the investor mood, along with the returns on risk assets, set teeth on edge.
What to make of all this? How could the mood turn so dark when just weeks before, global equities were in the midst of an impressive rally? Fuelling that rally: an impressive third-quarter United States GDP report that revealed the economy grew 5.0%, on the back of a 3.2% increase in personal consumption, and soundings from the European Central Bank that it is considering more aggressive actions to combat waning economic momentum in the currency bloc. The game changers, according to the bears, are twofold: an energy price in apparent freefall (Brent crude and West Texas Intermediate, also known as Texas light sweet oil, breached the $50/bbl mark); and the very real possibility that a left-of-centre government, Syriza, will be elected in Greece – one inclined to eschew the austerity of the last several years. But these developments may not change the game for long, as evidenced by the rally of the past two days.

The game theory of energy prices

There is a view floating around capital markets that OPEC’s failure to restrict supply is a principal driver of plunging energy prices. When ones thinks about OPEC, one is really focused on Saudi Arabia. The storyline here goes that the Saudis are happy to drive oil prices sharply lower long enough to cause damage to the U.S. energy sector. This sector has borrowed heavily to finance its exploration and production activity, and a period of sharply lower energy prices will impair the debt-servicing capabilities of these companies.[2] The waterfall of events in this scenario is dividend cuts, the cancellation of projects in development, slashed capital expenditure budgets, and then finally, a credit event somewhere among the weaker players in the space. If you subscribe to this line of thinking, a credit event wherein one of the oil exploration and production companies defaults on its debt obligation sparks capitulation within the energy sector, forcing further a decline in share prices. It will also impair the willingness of management to invest in new projects, as the threat of insolvency forces a husbanding of resources. The net effect of all of this is restraint in the growth of supply. Once the credit event occurs and capitulation follows, a cut in Saudi production returns crude prices to $60-$70/bbl level.
To be fair, energy companies have begun the process of cutting dividends, mothballing projects and cutting capital expenditures. A recent article from Reuters casts light on the shape of things to come: the dozen companies they examined revealed planned capital expenditure (“capex”) reductions of much as 50% for smaller operators and 20% for the larger players.[3] The sample size is not large, but it does align with other reports I have seen forecasting global declines in capex of 20%.

Get him from the Greek

Two concepts to keep firmly in mind: first, what someone does to acquire power is different from what they do when they actually gain power; in short, promises made during an election often cannot be kept after the election is won. Second, the Greece of today is not the Greece of 2009. To wit, the country’s budget deficit in 2015 is expected to be roughly 1.5%, according to Bloomberg consensus estimates, versus 15.7% in 2009. The euro zone is also not the same, as Germany continues to enjoy unemployment at lows not seen in decades, growth in Spain is stirring, Ireland has made tremendous progress righting itself, and most importantly, the European Central Bank is being led by someone who has no compunctions about acting as the lender of last resort. Indeed, the banking system in the euro zone is not the same banking system of 2011, as backstops have been instituted. Were the unthinkable to become the inevitable, it is far from clear that a Greek exit from the euro zone would be the Day of Armageddon many fear.


It is hard to interpret the drop in U.S. equity prices as a harbinger of things to come. The recent rally confirms our suspicions. The decline in U.S. equity prices at the beginning of the year reflected a pullback in a market that got ahead of itself. The S&P 500 Index jumped 6.13% from December 16 through December 29, effectively capitalising a year’s worth of earnings growth in 13 days. The expansive mood of investors was fuelled by an impressive November employment report and third-quarter GDP. While all of this put a positive glow on the waning days of the year, it would have been wishful thinking to believe it would remain uninterrupted.
Our conclusion: the European Union is far from doomed, the change in oil prices is not cataclysmic, and the equities selloff represents a correction. Whew. Next?

[1] Based on returns for the first three trading days of 2014 from Bloomberg’s world equity monitor in local currency.

[2] Roughly 13% of the Barclays U.S. Corporate High Yield Index is energy-related. The percentage is based on market value. Source: Barclays, as of January 6, 2015

[3] U.S. oil and gas companies cut capex and rig plans as crude dips, Reuters, December 10, 2014.
Hans Olsen, CFA Global Head of Investment Strategy

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