Growth worries spur closer oil and equities relationship
Both markets face volatility, contagion and unusual correlations
Traders in both the oil and equity markets have been blaming each other for their unsettling start to the year.
Yet both are being influenced by much larger changes in their common environment — changes that have increased codependency, aggravated asset class contagion, and suffocated, at least for now, some pretty obvious and potentially rewarding longer-term differentiations.
Equities and oil experienced a pretty awful January. Notable price declines have occurred in the context of wild volatility, including intraday swings. And the correlation between the two has been unusually high, with the asset classes tending to move together, alternating between sharply lower and higher.
As is often the case, quite a few analysts have rushed to attribute causation to such high correlation. Noting that energy names account for a sizeable part of the S&P index, large falls in oil prices are deemed to depress this component’s earning potential while worsening sentiment for equities as a whole.
For their part, oil traders feel that a sell-off in equities amplifies worries about global growth, dampening energy consumption forecasts and placing pressure on energy prices. And both worry that the disinflationary impulses accentuate the risk of a general deflation that would encourage consumers to postpone purchases in anticipation of lower prices in the future.
While there is some validity to these arguments, they are far from compelling as robust explanations for the rather unusual correlations that have developed between oil and equities around the world.
For a start, lower oil prices translate into huge windfall gains for consumers, leaving them with more cash in their pocket to spend on other items. Indeed, it is not so long ago that an oil price plunge was viewed as unambiguously positive for western countries — and also for quite a few developing economies.
To the extent that there is now more production taking place in the US in particular, the macroeconomic impact of the related losses is still less than the consumption gains.
The questionable causality is amplified by the lack of differentiation. The equity market sell-off has been indiscriminate, encompassing even airlines and also retail names that serve segments of the population that disproportionately benefit from the fall in oil prices, including lower income consumers. Similarly, only gold has been spared the generalised decline in commodity prices.
A better explanation of the correlation between oil and equities is that both are being influenced by three more general developments.
First, downward revisions in global growth projections on account of concerns about uncharacteristic policy mishaps in China and other emerging economies. This has added to the unsettled demand situation for oil and is placing a cloud over corporate earnings; illustrated last week by Apple’s revenue miss and its lower second-quarter guidance.
Second, the loss of safety nets. The December interest rate shift by the US Federal Reserve has crystallised an important reality for equity investors — notwithstanding Japan following Europe into negative policy rates, they can no longer rely to the same extent on central banks to uniformly maintain ultra-interest rates as a way of encouraging financial risk-taking and pushing more money into stocks. Meanwhile, the oil market is yet to recover from the shock of seeing Opec reject being the swing producer on the downside, or exiting its historical role of limiting production to counter a price decline.
Thirdly, there are very few sizeable balance sheets willing to step into markets, even when segments have visibly overshot. The countercyclical risk appetite of the broker-dealer community has been muted by both regulatory and market pressures.
The most patient sources of all investment capital, such as the Norwegian sovereign wealth fund whose liabilities are associated mainly with future generations, no longer have the spare cash they once had. And large institutional investors are increasingly anxious about giving up the returns of recent years, especially with the trauma of 2008-09 still fresh in their minds.
Rather than blame each other, both oil and equity traders need to realise that they are part of a much bigger reality. It is one that promises continued volatility, both up and down, coupled with excessive contagion, unusual correlations and some yet to be exploited opportunities for longer-term returns.
Mohamed El-Erian is chief economic adviser to Allianz, chair of President Obama’s Global Development Council, and author of the forthcoming book “The Only Game in Town”