Saturday, January 30, 2016

Oil, Stocks, Central Banks, The End of the Correction?? and Another Free Trade Bonus Section

At last (or, at the moment) oil and stocks have seen a, albeit somewhat, parting of the ways:    click to enlarge

Oil and spx the month of January 2016

So have the factors that joined the two suddenly dissipated? Good question! I guess we should try and determine what those factors are:

  1. Some believe that the oil industry in the U.S. has grown to the point where its pain more than offsets the joys of cheap gasoline, etc.

  2. Others believe it's a sign that the global economy is currently in recession, we're just too blind to see it.

  3. Others see it putting huge pressure on some emerging market economies (á la #2), and, thus, their currencies (a source of potentially huge global volatility in equity and debt markets).

  4. While still others believe that the unserviceable debt many industry players incurred at $100+/barrel is sending the kind of stress through the fixed income markets that have been reliable foretellers of past U.S. recessions, and, therefore, stock prices need to be bid lower, much lower.

I'm thinking it's a combination of 3 and 4: After the nightmare that was the 2008 recession, and the memories of the late '90s "Asian Contagion", anything that smells of stress in the credit, and currency, markets is going to send the equity market into a tizzy. The chart below shows the high yield credit spread (the difference between high yield bond yields and that of the 10-year treasury) and the past three recessions.     click to enlarge

High Yield Credit Spread

That's scary!   

And here's a 6 month chart of crude oil, the S&P 500 Index, the JP Morgan Emerging Currencies Index and JNK (a high yield bond ETF):


See what I mean in #3?

Of course, with regard to the first chart above, if we ex-out energy the chart would be less ominous, although it appears that energy is indeed weighing on other sectors. Here's a 6 month chart of the high yield spread for all sectors (the mountain) along with various other sectors (energy and materials at the top):

HY debt spreads by sector

So the question remains, since big bad bear markets are usually things of recessions, are we on the verge of recession? While I take very seriously the signals sent by the credit and currency markets, at this juncture I don't see great risk of a U.S. recession on the near-term horizon: Recessions tend not to begin when, for example, new and existing home sales (and prices) are on the rise, or when initial jobless claims are remarkably and consistently low, or when consumer sentiment and wages are growing, or, yes, when commodity prices are in the gutter (that typically happens during, and helps us out of, recessions).

Here's a link to my latest report (with charts) on key recession indicators...

Central Bankers to the rescue!

Even with Friday's monster short-covering rally (click here to see what I mean), the stock market just delivered its "worst" January since 2009 ("worst" in quotes because I think this is a much needed correction). And while periodic down markets are no sweat for you and me (right?), they sure do a number on the psyche of central bankers:

My, did Ben Bernanke ever leave Janet Yellen holding the bag! A bag bulging with $4.5 trillion worth of treasuries and mortgage backed securities---acquired from banks in exchange for cash that sits in their excess reserve accounts. Popular opinion has it that Bernanke and company did what they had to to avert the next Great Depression. Well, okay, but the job's not done until somebody figures out how to empty the bag so it'll have some room come the next recession---without bringing on the next recession in the process. Essentially, the Fed needs assurance that the economy can continue to grow while it, first, nudges the fed funds rate to a level that offers some semblance of normalcy and, second, begins to roll that massive debt pile off of its balance sheet. Hmm...

While I've expressed herein that the U.S. economy is presently not on the edge of the next recession, clearly, the Fed worries mightily about doing anything that would kill the wealth effect (folks do economy-growing stuff when their 401(k)s make them feel richer) and slow the presently modest rate of economic growth.

Add up the recent market volatility, the global landscape I described above, and the aggressive easing stance of other countries' central banks and you have the recipe for a (at this point) problematically  stronger dollar, potentially stressed credit markets and, therefore, a Fed that will be much more careful with interest rates than we thought just a few weeks ago. This realization (solidified by the Bank of Japan's adoption of a negative interest-rate strategy Thursday night*), along with a spike in the price of oil, sparked last week's short-covering rally in stocks...

*I've been asked to explain what it means to adopt a negative interest rate policy: I mentioned above that the Fed traded cash for bonds with the banks; and that the cash now sits in the banks' excess reserve accounts. Well, currently the Fed pays the banks 0.25% annually on all that cash; if the Fed were to adopt a negative interest rate policy they would turn around and charge the banks interest for sitting on all that cash. It would be like you putting a thousand bucks in a one-year CD with a 1% negative interest; a year later you'd cash out your CD for $990. Think maybe you'd find something better to do with that cash? Well, that's what the Japanese Central Bank is telling Japanese commercial banks. I.e., get that money out into the economy! And/or go exchange it for higher yielding U.S. dollars so the Yen will depreciate and make our exports cheaper for our customers. If you choose to just keep sitting on it, it'll cost you!

Is the correction over?

On January 20th the Dow saw an intraday decline of 566 points---followed by a 300 point rally---on heavy volume. Some speculate that that was the capitulation (click here for what that means) to end the current correction. While we can't know that for sure, we have to be skeptical. The potential for oil to reach back to the mid-20s is high at this point (suppose the Russians and OPEC can't come together), and I suspect, in that event, that we'd see that virtually perfect correlation to stocks spring back to life. Add in the ebb and flow of opinion over what the present state of global monetary policy means for markets at any given moment, and you have what has to be an extremely volatile environment for equities. Plus, as I've illustrated for you, not a single year in history that began like this one saw the market bottom in January. This very well could be the first, but we shouldn't hold our breaths... In fact, if you believe what I keep saying about corrections being very healthy phenomena, we should be very comfortable with the prospects for lower lows from here.


 Any other reason to tie oil to a weakening stock market?

I'm so glad you asked! Yes, there is, and this is one I doubt you've heard. And, were it advertised, this is one that too many misinformed Americans, alas, would prefer to dismiss (but they shouldn't). If you suffered through all of last week's update, you caught my little lecture on free trade. And you'll recall my view that when Americans buy foreign-produced goods they are expressing their patriotism in two most critical ways. One would be the simple fact that to be American means to be free, and to be free means to be able to transact wherever and with whomever on the planet you choose. Two would be that to send U.S. dollars beyond our borders is to support our U.S. exporters, as well as our financial markets.

As I'm sure you know, the U.S. is on the verge of energy independence. Wonderful!, right? Well, yeah, and, well, hmm...

Here's Bespoke Investment Group (emphasis mine) explaining how the fact that the U.S. now requires roughly $100 billion less oil from abroad equates to a net decline of roughly $100 billion in foreign purchases of U.S. assets (including stocks). And, as you well know, less demand for stocks means lower prices!
On balance, net asset purchases by foreigners across all assets have been negative to the tune of about $100bn over the last 12 months..

As the US requires less petroleum from abroad (down to just a bit less than $100 billion over the last 12 months), foreigners receive less dollars and that ultimately reduces demand for US assets.

Another present credit market concern is a seeming lack of liquidity in the treasury bond market. The financial regulation overhaul---post the 2008 recession---has made holding and, therefore, trading treasuries more difficult for bond dealers. As you may know, foreign entities have traditionally been huge buyers of U.S. treasuries (helping maintain a very liquid and, thus, low interest rate environment); should we embrace protectionist measures that would discourage the purchase of foreign-made products, we'd be depositing less claims on U.S. goods, services, assets and securities [U.S. dollars, that is] into the global marketplace and we'd be, therefore, exacerbating the liquidity risk that already has the attention of the Treasury Department.  

So, please, while today's candidates (you can easily identify at least one on each side) try to exploit the incredibly crazy and destructive myth that protectionism would in any way benefit the U.S. consumer, know that he/she is presuming that you and I are clinging to one of the grossest and most pernicious---yet, sadly, common---misconceptions.

1 comment:

  1. […] As for the correlation to stocks; here’s from last week’s update (click here for the full story with charts): […]