Our Perspective on Oil and Equity Markets’ Continued Volatility

Ouch. That is the first word that leaps to mind after Monday’s big financial market volatility. Equities plunged globally after Saudi Arabia flipped from trying to agree production cuts to slashing its oil price and pledging to increase output. That sent global crude oil prices down -30% Monday morning, before they recovered somewhat.^[i] The FTSE 100 fell -7.7% on the day, its sharpest drop since 2008’s Global Financial Crisis.^[ii] It closed -22.2% below its 17 January year-to-date high, whilst the MSCI World Index—which covers all global developed equity markets—closed the day -19.0% below its own prior high on 20 February.^[iii] Many define a bear market as an equity market decline that breaches -20%. That places the FTSE 100 in technical bear territory, with global markets close to this threshold. However, as we shall discuss shortly, magnitude alone doesn’t determine whether a decline is a bear market, in our opinion. Based on its other characteristics, including its speed and the prevailing investor sentiment, we think this decline is much more consistent with an equity market correction, when is generally more fleeting. Whilst there is no way to know how much longer this volatility will continue, we think investors seeking long-term growth will benefit most from staying cool and awaiting the recovery that we think awaits.

At this juncture, we think deciding whether to call this drop a correction or bear simply because the FTSE has crossed -20% is a distinction without forward-looking meaning. Whatever you call such a move, equity market history shows quick, steep drops tend to reverse about as swiftly.^[iv] Absent a major, lasting, fundamental negative—which we don’t think coronavirus fears or weak oil prices amount to—the rebound shouldn’t be far off, in our opinion.

The general sentiment in press coverage of Monday’s volatility appears to be that plunging oil prices add another blow on top of the coronavirus, all but assuring a global recession. In years past, many investors likely would have cheered such low oil prices as economic stimulus, arguing it gives consumers more flexibility to spend on discretionary items. But in 2014, the last time oil plunged, it didn’t have a material effect on consumer spending, and it forced oil firms to reduce investment. Their cutbacks rippled through oil-dependent economies as well as global manufacturing, causing a mid-cycle economic slowdown that lasted into early 2016. As a result, pundits are now penciling in another round of cutbacks—and worse. Many smaller American Energy producers have weaker balance sheets now than the last time around and risk running out of cash if they can’t continue tapping borrowers, causing a twin fear of bankruptcies wreaking havoc in the sector, potentially triggering a chain reaction through broader credit markets and the economy.

We won’t comment on the geopolitics surrounding the apparent oil price war—they are mostly speculation at this point and probably immaterial to markets, which we think care most about supply and demand. The why doesn’t matter as much as the reality of changing supply drivers, in our view. OPEC and Russia’s joint efforts to curb production seem over. The impact on global supply will likely depend on how American (and to a lesser extent Canadian, British and other market-driven producers) firms respond to the shifting financial landscape. Will they put the past few years’ worth of efficiency gains to work and keep pumping in hopes of retaining market share? Or will they hunker down? Only time will tell.

As for the broader market, we think this looks like a panic driven by emotions and speculation, not rational thinking. Monday’s drop wiped about £2.2 trillion off the MSCI World Index’s market value.^[v] Ask yourself: Has anything fundamentally changed to warrant that? Did £2.2 trillion of potential corporate damage just arise without warning? After surveying the landscape carefully, we don’t think so. Based on all the statistics provided by the World Health Organization, US Center for Disease Control and medical researchers at Johns Hopkins—as well as equity markets’ and developed economies’ long history of resilience in the face of pandemics—we think the market’s reaction to the coronavirus is out of proportion with its likely fallout. Our review of history shows no pandemic has caused a bear market. As for oil, the last time prices crashed, services industries held up fine. Many benefitted from lower operating costs as energy got cheaper. Some retailers got a boost when people didn’t have to spend as much on petrol. Manufacturing, oil drilling and adjacent industries struggled, but the services sector is much larger than those industries combined, and it pulled America and Britain along.

Some argue the coronavirus changes the oil downturn’s calculus this time. We don’t disagree, but we still think the impact should be temporary. Yes, several major events have been cancelled, which will undoubtedly have local consequences in the affected areas. Tourism’s struggles are well documented. But retailers are likely benefitting from higher demand for consumer staples and food storage—such as several retailers’ reports of spiking sales of freezers. We aren’t saying this activity will fully offset any short-term hit—it seems reasonable to expect some negative data in the weeks ahead. But we offer them as a reminder that the entire global economy hasn’t come to a screeching halt.

What matters most for investors, in our opinion: Equity markets are forward-looking, and they move most on the gap between expectations and reality. Market volatility has seemingly caused investors’ economic expectations to plunge. We have seen numerous headlines warning of unending global recession as the world allegedly rethinks globalisation and central banks run out of ammunition. Against this backdrop of dread, a few months of lousy data and some isolated gross domestic product (GDP, a government-produced estimate of economic output) contractions would probably be a positive surprise—not nearly as bad as feared. In the last mid-cycle slowdown, many worried struggling oil-reliant nations and weak manufacturing globally would combine to end the global expansion. Equities began recovering well before the data disproved those fears.

So we encourage readers to look forward—not just to tomorrow, but to the next several months and beyond. This is where equities generally look, according to our research. Carefully consider the question: Is the equity market decline commensurate with the likely economic damage—or is it worse? We suspect markets have overshot by quite a distance, likely teeing up a recovery as investors gradually realise the panic was unwarranted. Making a defensive portfolio move now risks getting whipsawed by the recovery. If your investment goals require long-term growth, we think participating in the recoveries that follow corrections is generally vital. In our view, those who can stay patient through these difficult times will benefit more than those who handicap their future returns for the sake of trying to avoid volatility in the here and now.