Monday, August 24, 2015

Climbing an oil-slick China wall of worry

Falling oil prices and Chinese growth concerns have come together in perfect-storm fashion to send global financial markets into crisis mode. As I mentioned last week, what's going on seems to have more to do with fears than with any deterioration of the economic fundamentals. It's one more in a series of "walls of worry" that the market struggles to overcome—only this time it's an oil-slick wall of worry which makes the climbing more difficult.

It's impossible to say whether the global economy will unravel—sending shares lower still as the fundamentals finally do deteriorate—but the market seems to be pricing in a good chance of such a possibility. If you're going to panic and sell here, you need to be very worried that we are on the brink of a global economic disaster.

Crude oil prices have now fallen by almost 60% from last year's high. They've gone from being very expensive to now a bit cheap from a long-term historical perspective. I'd also note that virtually all recessions in the past 45 years have been preceded and/or triggered by relatively high prices of oil in real terms. With oil prices now into their second year of decline, we've seen only a brief slowdown in GDP, so I'm tempted to say that lower oil prices now make the economy less susceptible to a recession going forward. Cheaper oil is bad for producers, but very good for almost everyone else.

The key risk factor is how vulnerable the balance sheets of oil producers are to today's low prices. High-yield energy bond credit spreads are one way to evaluate that risk, and not surprisingly, they are high and worrisome. Nevertheless, the losses sustained by these bonds to date represent less than 1% of the value of all traded U.S. corporate bonds. This oil "tail" is unlikely to wag the corporate/economic dog, but that assertion does little to soothe a market that worries we're on the brink of another global recession.

As before, I think this chart is key. Despite the huge decline in oil prices, a substantial increase in high-yield credit spreads, and the recent 10% drop in equity prices, swap spreads are relatively low and declining. This is a stunning (and very reassuring) disconnect. If we were truly on the brink of another recession, swap spreads would almost surely be high and rising—but they're doing just the opposite. This lack of confirmation (the swap dog that didn't bark) points squarely to the current market rout being driven much more by panic than any deterioration in the economic fundamentals. The current level of swap spreads tells us that markets are very liquid and systemic risk is low. A big economic disruption is thus unlikely.

It's notable that oil's most recent decline has coincided with a decline in the value of the dollar. On a long-term time scale, oil prices tend to correlate inversely to the value of the dollar, as the chart above shows. I continue to believe that recent action tells us that lower oil prices are the result of a supply shock (think fracking) rather than overly-tight U.S. monetary policy. It's not a shortage of dollars that is depressing oil prices, it's a surfeit of supply, and that's good news for consumers.

The most welcome impact of falling oil prices is lower inflation expectations, as seen in the chart above. The market now expects the CPI to average about 1.1% over the next five years, mainly because of sharply lower oil prices. But when the bond market looks past the current oil decline, it sees the CPI averaging 1.9% over the subsequent five years—that's the message of 5-yr, 5-yr forward inflation expectations built into TIPS and Treasury prices. That's very much normal.

It's also notable that the prices of 5-yr TIPS (using the inverse of their real yield as a proxy) and gold  have barely budged despite the recent global equity market turmoil. This is one of those scare scenarios that has caused large equity portfolio managers to hit the "sell" button—not a generalized unraveling of the global economy or financial markets.

The last time we saw a wall of worry this high was back in September 2011, when the PIIGS crisis reached its apex. Unlike today, however, swap spreads were high and rising in late 2011, as the world not only worried about the health of the Eurozone economy but also the health of the Eurozone banking system. Today, despite the huge increase in the Vix/10-yr ratio, swap spreads are low and declining.

U.S. and Eurozone equities suffered much greater losses in late 2011 than they have in the recent selloff. They rebounded nicely once the PIIGS crisis proved to be not so dangerous, and they can rebound again if the global economy fails to collapse.

And, by the way, US exports to China are only 0.7% of our GDP, so the health of the US economy is not terribly dependent on the health of the Chinese economy.


Benjamin Cole said...

Lots of excellent insights and blogging by Scott Grannis, and I hope we all fare well through this transition.

Something to ponder:

Robust housing construction is criminalized in the United States in almost every community. Ergo supply is artificially constrained. Ergo when we have you have economic growth often you get inflation in housing prices---this argument is a parallel to Scott Grannis' argument at an increase in the supply of oil is what is holding oil prices down, not tight money.

Just something to ponder.

Roy said...


Thank you for another excellent post.

My understanding of the current China scare is that if it continues with depreciation, it will possibly cause higher unemployment in the US with the trade industry (same concept as the oil industry) so if the impact of unemployment would be higher than the benefit of cheaper goods it will be deflationary. What are your thoughts on that? I guess this is exactly like the impact from cheaper oil, the only question is the scale, so,if you were trying to determine this from data and charts as you have done above, how would you go about doing it?

Going over your words, I couldn't really be sure if you are somewhat more pessimistic than before or you are trying to clearly state that only if one is certain about coming global collapse then one should sell.

Thanks again!

FactsAreFriendly said...

Please define "swaps" as you use the term and explain their role. Otherwise I cannot evaluate your discussion of them. A reference to sources which describe the uses and role of swaps would also be useful.

Many thanks for your very helpful comments and charts.

Ignorant in Dripping Springs, TX.

Joseph Constable said...

Yesterday's panic reminded me of the October 1987 panic which I watched. Here are some charts of the market action. I am not saying that this time the market will ultimately go to new highs. I am just pointing out the short term action that is likely to follow yesterday's panic.

Joseph Constable said...

I agree that 2 year swap rates are a supreme indication of investor sentiment. I also think we should watch credit spreads as they too are an excellent insight to investor sentiment. I put up the chart I follow.

Matthew Grech said...

Thanks, Scott. Excellent, and timely, post.

The Dude said...

To FactsAreFriendly. Here is a link to an earlier discussion. Another way to find is the search box in the upper left hand corner. Type "swap spreads."

marcusbalbus said...

You write the same post over and over. Good grief.

Johnny Bee Dawg said... write the same comment over and over. Good grief.

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steve said...

the only thing about yesterday that resembled 10/19/87 was the open. after that, quite quiescent. I was broker in '87 and it was literally epic. nothing epic about yesterday.

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Michael McGaughy / 麥德安 said...

Very good blog post. Thanks for writing and posting it!

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William said...
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