Stocks fell on Friday even after the government issued another strong employment report. Some pundits suggested the decline was tied to ongoing coronavirus fears, but equities rose a good part of the week amid the same fears. I think profit taking was probably a better explanation.
If the coronavirus was a cause for a modest decline in stock prices during January, the lessening of fears is hardly an explanation for stocks moving to new all-time highs. One can’t possibly suggest that the economic impact of the virus would be a net positive. Indeed, even if one were to assume that the peak number of daily new cases had already been reached, far from a certainty, the lingering damage is real and will probably be longer lasting than first noted.
As a case in point, let me point to the energy sector. The world has had an excess supply of oil and gas for some time. Some producers, like Saudi Arabia, have tried to balance supply and demand by holding back production. In normal times, this is a moment when oil prices start to rise as cold weather increases usage of products like heating oil, and refineries go down for maintenance before accelerating the production of gasoline for the summer driving season. Over 90% of the time over the past 25 years, oil prices were higher on Memorial Day than they were the previous Thanksgiving. But that is unlikely to be the case this year. China is the world’s largest consumer of oil and it is in partial shutdown paralyzed by the virus. Cruise ships are quarantined in port while stranded passengers get sick. Planes are grounded. Chinese GDP is unlikely to show any growth at least in the first quarter.
All this means demand is falling faster than supply. Inventories are building and the only way they will be worked down to normal is through supply cuts. That means less drilling. That means the urge to seek new oil reserves will decline. OPEC nations and others in which production is centrally controlled can turn off the spigot. But in free market countries like the U.S. the only thing that will stop production from existing wells is lower prices. A record warm January certainly doesn’t help. The virus impact could end tomorrow and it will take months, maybe years, for supply, demand and inventories to come back into balance. In the end, the answer is simple. Oil demand worldwide is flattening. Growth has been miniscule to begin with. The only factor saving the oil industry has been the natural decline rate in production. Each well, on average, produces about 5% less oil every year as it ages. Thus, the industry must bring on about 5 million new barrels of production every year in order to stay even. That sounds like a big number, but it isn’t.
State run oil companies are probably holding back 1-2 million barrels of oil just to hold prices where they are. Fracking in the U.S. was adding up to another 1 million barrels but that now looks closer to 500,000 thanks to lower prices. Production in Venezuela, Iran, Libya and Iraq are way below what could be produced for obvious political reasons. All are operating way below production capacity that existed a few years ago. Over time, that production will become available again. And there are areas of new production. ExxonMobil alone has a huge find off of South America that will soon add more than 1 million barrels per day. If the car industry moves away from gasoline and solar efficiency improves, both near certainties, the demand for oil will start to roll over and decline. That is already happening in developed nations like the U.S. and in Western Europe. The inventory glut accelerated by the coronavirus only worsens the problem.
With too much oil, that means less drilling activity. That lowers capital spending around the world. Today, the energy sector comprises less than 4% of the market value of the S&P 500. It has been an underperformer persistently for years. Low valuations allow for periodic rallies, and we may be due for one if the virus impact lessens, but I don’t see how the sector prospers over the intermediate-to-long term.
Energy isn’t the only industry impacted by the coronavirus, of course. U.S. companies have spent a lot of time, money, and energy reconfiguring supply chains over the past year. For the most part, that spending hasn’t been productive in the sense that moving production from A to B either lowers price or improves productivity. In most cases, it was a necessity to stay even on a cost basis. But as events like supply chain reconfiguration and reacting to the coronavirus take time, less time is spent on new CapEx programs.
What is being spent, however, is being spent mostly on steps to improve operating efficiencies. Plant automation, moving IT to the cloud, and beginning to use artificial intelligence all enhance productivity. Last week we saw that productivity rose 1.4% in the fourth quarter and was 1.8% higher than a year earlier. That doesn’t sound like a great number and it isn’t. But it is better than it was on average over the past decade and, combined with a 1.3% growth rate in the labor force, suggests that growth could accelerate to 2.5-3.0% if maintained. Remember, however, that we live in an oversupplied world. Spending on traditional items, like new productive capacity or more office space, is likely to remain constrained.
One other economic sector that is constrained is trade. President Trump has been a strong advocate of reducing our negative balance of trade. It appears he has gotten his wish but for the wrong reason. Exports and imports are both declining. The reason the trade deficit is down is that imports are declining faster than exports. To the extreme, the trade balance could disappear if worldwide trade simply stopped. That is hardly practical nor is it what anyone wants to see. The decline in trade is clearly tied to the tariff wars. If tariffs were pushing production back to our shores, it would evidence itself via enhanced manufacturing activity. In 2019, the opposite was true. A worldwide manufacturing slowdown prevented that. Perhaps with more trade peace this year (although tariffs remain in place), trade volumes could increase once again.
None of what I have said this morning is remarkably encouraging for a stock market at record highs selling at 19x forward earnings. Markets are going up despite retail investors continuing to pull money out of mutual funds and reinvesting in bonds despite almost record low rates. The only logical explanation for this is that at least some are concerned about lofty valuations and find bonds, even at today’s low rates, a safe haven. Time will tell if they are right. With both stocks and bonds moving higher, perhaps the best explanation is that central banks are rapidly increasing the supply of money. In a world of real assets, excessive supply means lower prices. In financial markets, excess money has to be invested driving prices up and future returns down. In the short run, that makes investors smile. We will discuss the long term consequences at another time.
Happy 53rd birthday to Academy Award winner Laura Dern.
James M. Meyer, CFA 610-260-2220