Chief Investment Strategist and Chief Economist
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After a highly unusual rise in correlation between asset prices and crude oil globally, financial markets appear to be recovering from a “state of shock.”
The world is drowning in cheap oil. At its recent low, the price of a barrel of Brent crude dropped 76% from its 2014 high of $116.
For energy-importing countries, this has been a boon, lowering costs for consumers. But it has also wounded significant parts of the world economy, particularly energy-exporting countries. It has created a financial challenge for producers to repay liabilities incurred when oil prices were much higher. The effects have spilled over into world financial markets, with even oil-consumer equities moving unusually closely with crude in recent months. Could the oil exporters’ pain spread even further, dragging the world economy down with it?
The risks of a spreading financial shock aren’t negligible. We see the US business cycle as now being in its later stages and less resilient to shocks than it was earlier on. There’s a danger that a significant new shock could derail the economic expansion, both in the US and globally.
Investors became unusually wary of this at the start of 2016. Even after huge oil-price declines, recent market pricing suggested some investors expected another halving in oil again over the rest of 2016. Another potential shock could come from China’s exchange rate. With private capital flowing out of China and possible action from the central bank, a further devaluation could trigger yet more turbulence in global markets, just as it did in August 2015.
That previous episode saw global equities drop 12%, a move that was subsequently mostly reversed when no economic contraction ensued. The absence of new lows in China’s currency over the past two months suggests a desire of Chinese authorities to maintain tight control. With deep declines in investment outlays in the energy sector, the current glut in supply is likely to shrink over time. Oil’s stabilization over the past month has eased worst-case fears of producer-debt distress. Meanwhile, in the US, a broad range of industry groups show no sign of following the energy sector down.
In our view, the August scenario is likely to repeat itself, with the world’s slow and disappointing economic expansion continuing, and markets recovering. If risky assets do indeed recover in the now-familiar pattern, we would seek to continue de-risking our allocations. Even before the sell-off, we had already reduced our equity overweight by half over the prior year. However, for those investors that have remained deeply underweight equities relative to their target allocation, we see the recent sell-off as representing more opportunity than risk.