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.