The Envestnet Edge, December 2015
Interest Rates, Energy, Commodities: The Highs and Lows of Year-End
The Fed. Interest rates. A stressed bond market. The Paris climate accords. What do these things have in common, and what does that commonality portend for portfolios?
For the past few months, financial markets have been positioning for a change in Federal Reserve policy to move from “very easy and accommodative” to “easy and accommodative.” The decision of the Fed, finally, to raise short-term lending rates by 25bps was met with relief that months of will-they won’t-they were finally over. At the same time, the energy and commodity complex has continued to melt down as prices plummet. The result has been both an unusual amount of turmoil in fixed income markets and a rising chorus of voices anxiously drawing parallels to 2008-2009.
Although the past months are a prime case of financial market unrest, it is likely not a sign of real world economic crisis in the making. In fact, in this instance, there may well be an inverse relationship between dislocations in finance-land and real world benefits, as the Paris climate agreement demonstrates. What is bad for energy companies and challenging for fixed income is likely to be a boon for consumers, companies, the planet, and, soon enough, financial markets, as well.
What’s ailing fixed income?
Ahead of the Fed’s decision, fixed income markets came under notable stress. Spreads between high-yield credit and U.S. Treasuries have widened rapidly, from an average of 170 basis points in 2014 to almost 700 bps now. Both the pattern and the size of the gap resemble what happened in the 2007 run-up to the financial crisis the following year. And hence the widespread concern that the stress in these markets today could presage something quite severe for both bonds and stocks in the year to come. That pattern also was seen in 2000 as the Internet bubble burst.
Of course, the market was under similar stress in 2011 with the Greek and Eurozone crisis, and it did not lead to either an equity or bond crisis, largely because of concerted central bank action in November 2011. That history shows that these past patterns may or may not be a harbinger of bad things to come.
It is also vital to look at the reasons for the weakness in the fixed income markets and from where it stems. The primary culprits are the energy and commodity complex and emerging market debt. While energy and commodities represent less than 15% of the overall high-yield market, that percentage is on the high-end of the spectrum relative to past percentages. And it has been so weak in response to the vertiginous collapse of prices that it has implicated other parts of the fixed income spectrum. In addition, it is unfolding just as the Fed has signaled a beginning of a very modest tightening cycle, which has made investors less willing to fund riskier assets.
The result, as we know, has been a widening of spreads and a general sense of unease in the fixed income markets. But the comparisons to past canaries in the coalmines may be premature. In 2007-2008, the number of bad loans was magnified many times over by the sheer size of derivative exposure and the securitization of those loans. Securitization and derivatives have hardly gone away, but in response both to the losses sustained during the financial crisis and a more stringent regulatory framework, the large investment banks and a host of other market participants have pared back on derivative issuance. Although there are “dark pools” of capital whose components are murky, it does appear that even if today’s stress were a sign of systemic issues, their consequences are unlikely to be as dire.
What we have then is a financial system issue. But the very thing that is generating that strain also is poised to become a real benefit to companies, consumers, and to economies overall in 2016 and beyond.
The upside of the downside
The weakness in the commodity and energy complex, the concomitant strain on emerging market and high-yield debt, and the general stress on fixed income markets is, however, juxtaposed to a real-world shift. And that shift should be immensely beneficial: greater efficiencies and lower costs as the world moves away from extractives and towards renewables, composites, and greater integration of technology.
Regardless of one’s specific views about climate change, the Paris conference and the welter of variations in how countries and companies are approaching their carbon intensity represents a sea change. Governments may or may not integrate the targets set at the recent conclave. But most multinational companies, and a multitude of smaller businesses and consumers world-wide, are weaning themselves rapidly from reliance on the raw material inputs that have shaped the industrial revolution and global growth through the end of the 20th century.
As the global structure of production and consumption of raw materials shifts, the most obvious initial sign is the disruption it causes. The collapse of oil prices, falling below $50 a barrel and heading south, has put major strain on oil-dependent economies such as Russia, Saudi Arabia, and Venezuela. It has hurt the booming shale and oil economies of the mid-United States stretching from North Dakota to Texas; and it has dented Canada’s growth. The collapse in raw material prices has put pressure on Brazil, Indonesia, South Africa, and others. In addition, the shift in China’s economy away from heavy industry and building stuff has further dampened prices and demand.
But going forward, especially for the United States and developed economies, the far lower energy prices and less intensive energy use is a massive tax cut for consumers and companies. The share of spending on gasoline has declined for the average American as prices for gasoline, heating oil, and natural gas have dropped. And companies’ ability to maintain margins also has increased at a time when top-line revenue growth has slowed. Reducing cost of goods sold has allowed companies to remain more profitable than many thought, given the generally anemic state of global growth.
Add to the mix the continuing efficiencies of technology and robotics, and the degree to which those also consume less energy, and you have a recipe for significant positives both for companies and the hundreds of millions of people whose incomes may be static. Lower costs are an unequivocal boon for them, even as they create short-time disruptions in financial markets.
That benefit is only beginning; the effects of the disruptions and dislocations already are unfolding. For the moment those are disruptions appear negative, especially for certain sectors of the financial system and certain parts of the world. While the negative effects of those dislocations may continue or even intensify, they soon enough will be offset—or should be—by the boost to consumer spending and corporate margins that these shifts in energy and commodity usage portend. And that boost should be a tailwind for companies, for equities, for national economies not dependent on raw materials for output, and for the global economic system in general in the year ahead.
Market volatility, fueled by plummeting energy prices and rising high-yield rates, is causing investors to question whether this is a replay of the 2007 run-up that led to the financial crisis. The decision of the Fed to moderately raise rates was actually greeted with a collective sigh of relief in financial markets, but it is too soon to say whether that relief rally is the beginning of a new uptrend. Comparisons to past crises remain front and center for many investors. Still, past isn’t always prologue: similar events in the Eurozone in 2011 did not end in crisis. Real-world shifts in reliance on raw material inputs mean greater efficiencies and lower costs for companies, making them more profitable in the wake of anemic global growth. And lower prices for gasoline, heating oil, and natural gas portend a boost to consumer spending and a tailwind for companies, equities, and the global economic system.
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