Last week was one of rapid whipsaw movements in both directions. But with that said, today is shaping up as one of the worst trading sessions in recent memory, sparked primarily by a failure of Saudi Arabia and Russia to agree on measures to reduce the supply of oil to match falling demand related to the coronavirus.
Oil prices have plummeted more than 20%. In the early morning hours, they hovered around $30 per barrel after Saudi Arabia reacted to Russia’s unwillingness to negotiate by announcing production increases and sharply lowering its own selling prices. At $30 per barrel, all new investment in new drilling will stop. Some existing production will be shut down. The spigot cannot be shut off immediately however. It will take several months of sharply lowered production to balance supply and demand. In the meantime, prices could go even lower. Russia could come back to the negotiating table at any time, but much damage has been done. Oil producers with any significant leverage will suddenly be pushed into survival mode. Some won’t survive.
We last saw sub-$30 oil briefly in 2015. What we have learned over the weekend, if it was not clear previously, is that OPEC is dead. OPEC controls only a little over a third of world production today. Obviously, as we see this morning, Saudi Arabia, the largest OPEC member, still has the ability of creating temporary havoc. But we now live in a world where a cartel like OPEC can no longer offset natural economic forces. The world is awash with oil and the only way to achieve balance is for supply to fall into line with demand. Even assuming that Saudi Arabia doesn’t follow through with its threat to raise production, it will still take many months to work off excess inventory. The natural decline rates of existing wells, over time, could help to restore balance as drastically lower prices force large amounts of production to disappear.
Oil isn’t the only issue this morning. The spreading coronavirus is pushing governments toward some forms of quarantine. Major conferences and events like SXSW are being canceled. Theme parks are closing. Cruises are being canceled and airlines are flying reduced schedules. Schools are closing at least through the end of March in many areas. From a health and safety point of view, these appear to be sensible steps to contain the spread of the virus. Long history, going back to the Spanish influenza outbreak of 1918-1919, show that similar steps can mitigate the damage.
But what is good for health and safety can be a disaster economically. In a global world where all big multinational companies have interconnected supply chains, disruption is inevitable until the virus peaks and recedes. While Chinese data says that could happen in 2-3 months from the start of an outbreak, no one really knows. Strong balance sheets will enable large companies to weather the storm. But that can’t be said for everyone.
In short, we are entering unchartered waters. Investors understand that short-term disruptions related to the virus will pass. Long-term values will be sustained. But not for all. For some, the damage could be fatal. For others, it could take years to recover. The Federal Reserve and other central banks over the coming weeks will take whatever steps they can to ensure liquidity in the system. But now we are beginning to see the pain of too much debt even when debt service costs are low.
Futures won’t tell the whole story this morning. There is a 5% downside limit that has already been reached as European markets open. Many stocks in Italy can’t even open.
As I have been noting for years, the world is awash in excess capacity. A deadly virus is hardly the best way to solve that problem. But the after-effects are likely to be an economic slowdown that will serve to withdraw some capacity from markets. Until then, we will have to live through the pain of lower prices needed to drive out production and lower profits. The odds of an immediate recession have escalated. The oil industry likely is already in one. With yields plummeting, banks will become very hesitant lenders. One bright spot is housing. Low rates are causing a spike in refinancing activity and an increased appetite to buy new or existing homes. But even that is tempered by virus fears. Who wants to host an open house not knowing if those walking in the front door are infected with the virus or not? Retailers of essentials are seeing a spike in activity as many stock up for a long haul. But those benefits are temporary.
The bottom line is that economic growth is likely to sink much faster than we thought a week ago, as more and more governments take steps that are prudent from a health and safety point of view, but devasting, at least in the short run, from an economic point of view. That means profits for at least the next two quarters will decline sharply. Even when the virus threat subsides, broken supply chains will mean that catching up won’t be quick for all. And as noted in my oil industry comments above, some won’t survive.
In tough times, the strong take share from the weak. They have capital and more alternative options. Small businesses that can’t fund either mandated shutdowns or loss of business due to less traffic will have to lay off workers. That hasn’t shown up yet in the U.S., but it likely will in coming weeks.
Equities are priced based on the present value of future cash flows. The impact of one or two very weak quarters doesn’t diminish long-term value much. But that presumes not only survival, but survival in a healthy enough condition to continue to grow long term. Equities are already down over 10%. Today will push many into bear market territory, down 20% or more. Is that enough of an adjustment presuming the virus threat passes in a couple of months. For most, it could be. But it will vary industry by industry and company by company.
Lenders don’t want to force default if there is sunshine over the horizon. Lower rates may help some borrowers. It is hard to believe that Russia and Saudi Arabia won’t have some conversations to try and stem the crash in oil prices. But even if they do, major damage has already been done.
Near term, the downside risk is greater than the upside potential meaning the risk of the 10% move in stocks is more likely down than up. But selling stocks in October 2008 when Lehman Brothers, AIG and Fannie Mae were crashing simultaneously didn’t look good for long. Within a year, stocks were well above their October and November 2008 lows. I suspect the same will be said this time around.
Again, that doesn’t mean there are bright skies ahead for all companies and all industries. For some, the damage will be too great. In 2008, the eye of the hurricane was in the financial sector. More than a decade later, some major banks still haven’t recovered to anywhere near pre-financial crisis levels. This time around, leisure and hospitality, as well as the energy sector, are in the center. Retail will also be impacted. Mall traffic will plummet.
But there will be sun over the horizon. Low interest rates will spur more housing demand. Low prices for energy will put more cash in consumer pockets. Most businesses will be able to survive 1-3 months of curtailed activity. The severity of the storm will dictate how long recovery will take. Panicking is never a great solution. Maintaining asset allocation balance might even push some to switch from bonds to stocks. That isn’t likely to happen today. But with Treasuries all along the yield curve now returning less than 0.5%, solid companies with good cash flows and increasing dividends are going to look very attractive before too long.
There is no doubt weaker hands will be near-term sellers. Some simply can’t afford to see nest eggs drop below certain levels even if the drop is only temporary. But those who understand long-term values will bargain hunt over time. With that said, stocks are not extraordinarily cheap, especially if one haircuts forecast earnings for the next two years, but a more healthy amount than appeared logical last week. Where is the bottom? In time, I would guess within the next month or so. As to levels, perhaps there is another 10-15% or so risk to the downside, assuming a sharp economic retreat over the next two quarters and a gradual recovery after that.
Today, actor Oscar Isaac is 41. Lester Holt is 61.
James M. Meyer, CFA 610-260-2220