The smoke is clearing after one of the worst days ever on global markets and many investors are walking around in shock. Even as the sell-off moderates, we’re skirting the edges of a global bear market and the confidence of 2019 has completely evaporated.
What we’re experiencing right now is an unusual combination of headwinds – a potential global pandemic in the coronavirus, plus an unprecedented global oil price war. Taken together, these shocks are causing major market pain.
Now, it’s important to remember that the stock market is not the economy. The economy is people making things and selling them, buying things and using them, getting their wages and spending them.
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The stock market is more a measure of sentiment, risk appetite, and macro-factors like interest rate differentials and exchange rates. Stock market performance is related to broader economic performance, but they’re not perfectly correlated. You can have a strong economy with a mediocre stock market and vice-versa.
So, what the market does and what is happening to the economy may be two different things. The stock market is, however, a fairly good indicator of risk appetite and risk fears. With that in mind, let’s look at what’s happening.
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The world is facing an unusual combination of simultaneous supply and demand shocks. On the supply side, the coronavirus has taken a toll. Large parts of China shut down for a month as the epidemic grew, and factories closed up shop (temporarily, we hope). This meant that the customers of those factories – which include many other factories that buy components – are now struggling with a lack of supply. Unable to find the parts they need, some factories are pondering temporary shutdowns, which would create further supply problems down the line.
At the same time, the coronavirus is creating demand shocks. People are cancelling their flights, delaying their holidays, avoiding bars and restaurants, and holding off on major purchases. Even though the coronavirus hasn’t yet reached global pandemic proportions, the fear that it might has led many people to put their spending and travelling plans on hold. The fact that many regions may be facing shutdowns, furloughs, and quarantines is making consumers even more nervous. Few people want to make a major purchase when they may be facing lost income if their workplace closes for a few weeks to deal with the coronavirus.
So, on the one hand, we have problems in the production and supply side of things and, on the other hand, we have nervous consumers cutting back and adopting a wait-and-see attitude.
Now, into this uncertainty has come an oil price war. Here’s what’s happened in a nutshell.
OPEC is a multi-country oil cartel, which exists to try and manage the oil price by limiting supply when demand is low and raising it when it is high – the goal is to keep the oil price high enough to be profitable but not so high that people switch to other energy sources. Right now, OPEC wants to cut oil production because demand is falling.
However, Russia – a major oil producer – is not interested in making cuts. That’s because Russia wants to put US shale oil companies out of business.
In the last few years, the US has become a significant oil exporter on the back of shale oil, which is extracted using fracking. Shale oil is expensive to extract, so shale oil companies need a fairly high oil price to be profitable. In practice, this means that a low oil price will put many shale operators out of business. This would be good for places like Russia and Saudi Arabia, which extract oil the cheap and old-fashioned way – by drilling.
Accordingly, Russia wants the oil price low enough to get the US out of the oil business. It, therefore, refused to make the cuts that OPEC, led by Saudi Arabia, wanted. In retaliation, the Saudis have launched a price war. They have pulled out all the stops on production – essentially saying that they are going to flood world markets with cheap oil. Oil prices responded with their steepest falls in around 30 years.
The Saudis are lucky. They are among the lowest-cost oil producer in the world – some experts estimate that their best oilfields are profitable at prices as low as $12 a barrel. They also have a lot of foreign currency reserves. So, even though they risk a lot of economic pain by starting a price war, it’s likely that the Saudi oil industry will survive.
With prices this low, however, the US oil industry will not survive. Most shale producers are heavily indebted and already facing production problems. Even before the price war, fracking was looking like bad business. Oil at $20 or $30 a barrel will put many shale firms out of business.
What this all means, bottom line, is that the impact of the oil price war is likely to be mostly negative. First, it will put a major strain on oil-producing countries’ budgets. Even Saudi Arabia will have to cut spending if prices stay low, as will governments from Russia to Nigeria. This could lead to recessions in those nations, with knock-on impacts for the rest of the world.
Second, the US shale business will see bankruptcies. This could cause problems in US debt markets. Shale companies have been big borrowers and if they default, the US corporate bond market – one of the world’s largest debt markets – could get very bad indeed.
Third, falling oil prices are unlikely to do much to stimulate the oil-buying parts of the world. Normally, low oil prices are good news because they mean that people will start to spend more. But with airline demand collapsing and people hunkering down in quarantine, even very low oil prices are not likely to get consumers spending in a meaningful way.
So, this is the backdrop for the market rout. The coronavirus has caused supply disruptions and dampened demand. Now, the oil price war is likely to hurt spending by many governments and perhaps send US corporate debt into a spiral.
Unsurprisingly, all of this has affected businesses. Many companies have announced changes to their profit forecasts and issued revenue warnings as sales drop. Businesses are holding back on investment because they can’t predict which way things will go – which, by the way, means lower future supply – a vicious circle.
Investors have taken a look at all this and decided that the wisest response is all-out panic. There has been a massive flight to safety. US Treasury bond yields have fallen to almost ridiculous lows as capital has flooded into the safe haven of US government debt. Stock markets have been savaged by selloffs. And, perhaps most worryingly, there are signs that the panic is hitting credit markets. Commercial paper – very short-term debt issued by companies – has seen yield spikes, a sign that investors are worried about corporate defaults. Investors have sold off leveraged loan funds aggressively, for the same reason.
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This means that it is likely to get harder for companies to borrow at the very moment when they may need short-term financing the most. And this means the possibility of more production cuts, retrenchments, and even business failures. Another vicious circle.
In short, the situation in global markets is highly volatile. The unpredictable nature of the coronavirus crisis and the unexpected nature of the oil price war have combined in a perfect storm of uncertainty.
Right now, we don’t know what the real economy is going to look like in six months. It may be bad; it may be fine. There are too many unknowns to make a reasonable prediction.
What we do know is that the markets are sending red alerts – investors are fleeing risk as fast as they can and, for asset prices at least, the outlook is bleak.
