Now that MSCI All-Country World Index has entered a bear market...
On Sept 6, 2013, crude WTI closed at $110.53/bbl. Yesterday, crude WTI closed at $27.30/bbl. The net move was a loss of 75.30% in the 29-month period. There are several primary factors that contributed to the meltdown in crude pricing, some domestic, others international. In the case of the former, US producers, through technological innovation and massively improved efficiency by way of horizontal drilling and fracking, were able to produce domestic crude and natural gas in regions of the continental United States that were previously thought to be off-limits. Those fields have become familiar to many: the Bakken, Eagle Ford, Permian, Marcellus, and Utica to name a few. The massive increased US production effectively put not only a cap on prices but also provided a strategic energy asset to the United States that it had not had in half a century. The supply component to the energy matrix has changed forever as a result, and in so doing has assured the US of energy security for the foreseeable future. That security has come at a price, however. That price is global energy market turmoil, a disruption in the geopolitical energy matrix, and in some cases political/regional instability. Exacerbating the impact of the increased supply component of the narrative was the entrance of crude supply from other regions of the globe, from increased production by Russia and elsewhere, to Iran's entrance into global markets in a post embargo world. OPEC, long the arbiter of global pricing has increasingly become less dominant in the new "free for all" world of energy.
A Shift to Slow Post-Crisis Growth
As if to magnify the impact of surging crude supplies on deteriorating prices, the global economy simultaneously began a shift to significantly slower post-financial crisis growth. From the European Union to China, Japan and much of the emerging world, growth has either slowed, stalled or gone into reverse. That slowing dynamic has had a materially deleterious effect on crude pricing at precisely the most inopportune time. Increased production, coupled with slowing demand has left crude pricing in a tailspin. Naturally, less efficient producers both here in the United States and around the world are folding up shop, laying off workers, reducing R&D spending and cutting dividends/guidance. Markets have been pricing that into crude for some time now.
The energy sector was the largest component sector of the S&P 500 before this recent fall from grace by crude at the hands of surging supply and weak global demand. Energy shares have fallen precipitously over the past two years, and in the process have weighed on the broader market and S&P 500. Despite that headwind, markets were able to withstand the mark down in energy shares as financials, technology, healthcare, pharma, home building and construction remained relatively healthy. However, increasingly, financials have been thought to be most sensitive to the ongoing struggles in the energy sector as a result of potential exposure to bad loans in the space. That fear started a run on financials that was augmented by the recent weakening of economic data here in the United States, below target inflation and anemic wage growth among other factors. Additionally, nearly every major ratings and forecasting agency here in the US has lowered growth forecasts and equity market expectations for the 2016 calendar year since the year has begun. Increasingly we hear the dreaded "recession" term being tossed around. The combined forces of slowing growth here at home, a crippled energy sector and global demand weakness have all played a part in the massive selloff in financials specifically and in equity markets in general.
The Global Effects of China's Stalling Economy
To make matters more challenging for investors, as crude was collapsing, China was slowing as the other major economic engines of growth around the word stalled simultaneously. European markets, long driven by German and French economies, are now being kept afloat by an extremely accommodative ECB, as peripheral economies in the zone swung from crisis to crisis. Japan has gone so far as to introduce negative interest rates and China is on the brink of a political test of leadership as growth continues to be below projections. In an effort to remain globally competitive the PBOC devalued its currency, the yuan. That move set in motion yet another sharp trade lower in Asian and Chinese equities, which further undermined US investor confidence.
As a backdrop to this emerging world of heightened volatility in energy and equity markets there is the Federal Reserve's monetary policy. Chair Janet Yellen took the reins of the Fed from Chairman Bernanke as the policy of the Fed was migrating from a focus on QE to normalization at precisely the same time as the world's economy was beginning to exhibit signs of demand weakness. Increasingly, it was clear that the US economy was performing significantly better than its peers, which left the Fed in a bit of a pickle. Does the Fed raise rates at a time when nearly all other central bankers were easing? What impact would that have on the US dollar? Trade? Energy?
In short, the impact of the long deferred move of 25 bps in December by the Fed lit a fuse of chain reactions. The US dollar has increased in value, crude has slumped further, trade has only modestly been impacted thus far, earnings projections of multinationals have been lowered, equity market valuations have been sharply compressed, world equity markets have careened into a bear market and investors are panicked. The Fed, meanwhile, has made it clear, through both Chair Yellen and Vice-Chair Fischer, that the Fed is inclined to raise rates several more times this year despite the drop in the 10-year yield to 1.65%.
What hasn't helped equities has been the string of disappointing Q4 results and guidance posted by many widely held technology stocks. The selloffs in names like Apple, Inc. (AAPL), LinkedIn (LNKD), Tableau Software, Inc. (DATA), GroPro (GPRO), Fitbit (FIT), and others has sent the NASDAQ to its lowest level in years. Nearly every stock with a valuation considered extended has been sold in the process, as "risk-off" has become the mantra spoken in every language in all corners of the investing globe.
Enter Contingent Convertibles (CoCo's) - The Most Recent Fuel for the Dramatic Selloff in Financials
“CoCo's are a perfect pro-cyclical storm — you can sell billions of them when investors are yield-chasing and thus careless of risk,” said Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics. “In a yield-chasing stampede like that of the last few years compounded by ultra-low rates for other bank funding sources, banking-system risk is dramatically heightened.” - Bloomberg News
The most recent trigger for sellers has been the emergence of a financial instrument that has largely been under the radar in recent years. CoCo's are high yield investment instruments that have been used by European financial concerns as a way of raising Tier I capital, offering relatively higher yields in a zero interest rates environment. The hybrid product removes risk from taxpayers and places it on holders. That risk was largely ignored when markets were moving higher or stable. That has changed. The fear that has emerged and manifested itself in panic selling of European financials is that when push comes to shove, these instruments may not be able to stand up to massive liquidation without seriously impairing the welfare of the institutions that have sponsored them or the investors that have bought them. That selling of European financials has bled into US financials - already compromised by the back drop outlined above.
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