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Are stocks up or down this week? It seems that is dependent on whether oil prices are up or down.
It wasn’t always this way. Between 1987 and June 2014, the overall correlation between weekly (%) changes in the S&P 500 index and the price of WTI crude oil was only 0.10 – we use weekly ending price data from Yahoo Finance and FRED Economic Data . However, crude prices collapsed after mid-2014, falling from about $105 a barrel to less than $30 a barrel by February 2016. The correlation jumped to 0.39 during this 20-month period.
Over the 12-week period running up to February 19th, 2016, the correlation sky-rocketed to 0.88. The following chart shows why.
While the relationship between stocks and oil prices have always been volatile, this lockstep movement has been surprising. The U.S. economy is far from being a proxy for oil, with mining and energy making up slightly less than 3% of the economy. Energy companies are over-represented in the S&P 500 index relative to the overall economy but their weight in the index is less than 7% . Adding the Materials sector still leaves you less than 10%.
Several commentators have noted that, if anything, low oil prices should only help consumers, and therefore boost consumption related sectors which make up most of the stock market. However, we have not yet seen consumption markedly pick up as a result of lower gas prices. At best, given the boom in shale energy in the U.S. over the past few years, and the subsequent pullback as oil prices plummet, the net effect would simply be neutral. Yet this has not been the case.
Weak global demand and elevated volatility
The most obvious answer appears to be a fall-off in global growth, reducing demand for crude oil while also reducing earnings for American companies that have a large number of customers abroad (and make up a significant portion of the stock market in terms of capitalization).
Ben Bernanke, the former chair of the Federal Reserve, was the latest to explore this issue. In a recent blog post , Bernanke investigated the hypothesis that underlying changes in aggregate global demand explain the oil-stocks relationship. He uses the premise that commodity prices (other than oil), long-term interest rates, and the dollar are likely to be sensitive to investors’ perceptions of global demand, as opposed to just changes in oil supply. As an example, he notes that when a change in the price of oil is accompanied by a similar change in the price of copper, this model concludes that both are responding primarily to a common global demand factor.
However, he finds that only 40-45 percent of the decline in oil prices since June 2014 can be explained by a slowdown in aggregate global demand. This clearly does not complete the entire story.
Bernanke then investigates the possibility that investors retreat from commodities as well as stocks during periods of high uncertainty and risk aversion. Shocks to volatility may be another reason for the observed tendency of stocks and oil prices to move together. Yet, adding this component still did not completely explain the lockstep movement, and he concludes:
“The tendency of stocks and oil prices to move together is not a new development; it goes back nearly five years (the limits of our sample) and probably more. Much of this positive correlation can be explained by the tendency of stocks and oil prices to react in the same direction to common factors, including changes in aggregate demand and in overall uncertainty and risk aversion. However, even accounting for these factors, the residual correlation is close to zero, not negative as we would expect if it were capturing only beneficial supply shocks.
There are several other explanations that could be investigated: for example, the possibility that declines in oil prices, even if initially caused by higher supply, affect global financial conditions by damaging the creditworthiness of oil-producing companies or countries. This topic is one well worth revisiting.”
In this post we dig a little deeper into his final point. Specifically, as to how the decline in oil prices are affecting oil-producing countries, and how this may be a proximal cause for the tandem movement in stocks and oil prices.
A shortage of petrodollars
Petrodollars are essentially the U.S. dollars earned by oil-exporting nations for selling their oil on the global market. After the financial crisis, as oil prices recovered to more than $100 a barrel (by 2011), the major oil-exporting nations accumulated billions of dollars in reserves, swelling the coffers of their respective sovereign wealth funds (SWFs). SWFs are essentially state-owned investment funds that typically prefer returns over liquidity, and thus have a higher risk tolerance than traditional foreign exchange reserves.
As of December 2015, 56 percent of the $7.2 trillion in SWFs were oil and gas related. Eighteen of the top thirty SWFs have their coffers filled with revenues from oil and gas. The top five – four of which are oil related – have $3.6 trillion between them (shown below).
SWFs in turn invested their petrodollars across the globe in a variety of assets, including U.S./emerging market debt and global stocks. According to the Global Macro Credit team at RBS, during the boom years oil-exporting nations found themselves needing to invest $700-$800 billion a year, net of extraction costs ( via FT Alphaville ). Just to get a sense of scale, petrodollar investments across the globe during the boom years of 2010-2014 were of similar size to the Federal Reserve’s Quantitative Easing (QE) programs. Now it is reversing, in addition to the fact that the Fed ended QE in October 2014 and is on a path of tightening.
As we discussed on top, plunging oil prices was initially thought to be expansionary, especially for consumers in the U.S. and Europe. However, Nobel prize winning economist Paul Krugman makes an important point on the non-linearity of plunging oil prices. While a 10-20 percent decline in prices (or slightly more) might indeed prove to work in the conventional way, a 70 percent decline really constrains producers.
In other words, oil falling from above $100 a barrel to about $60 a barrel has less of an impact on the balance sheets of oil-producers than when oil prices are cut in half from $60 to $30 a barrel. The level of oil prices may matter more than the actual percentage decline.
Uncharted waters for Norway
The crash in oil prices has clearly stung Norway, as economic growth has stalled. The nation is now expected to make its first-ever withdrawals from its SWF – the largest in the world – in 2016. In October the government unveiled a budget that uses a record amount of oil wealth to support growth, while withdrawing $570 million from its SWF. Since then, oil has been cut by a third, dropping into the low $30s. Just this past week, Oeystein Olsen, governor of Norway’s central bank, said the withdrawal may have ballooned to $9 billion.
As the nation continues to get buffeted by low oil prices, the central bank is making ever more purchases to keep its currency stable. The bank increased its purchases of the krone in February, to $104 million a day, from $58 million a day in December. Note that the bank only started purchasing kroner for the first time back in October 2014, just after oil started its downward slide.
Saudi Arabia slammed
The case of Saudi Arabia is even more stark, and best encapsulated by the free-fall in reserves.
The country still has seemingly formidable reserves but as the chart shows, its falling fast. In the eighteen months leading up to December 2015, Saudi Arabia’s reserves fell from $746 billion to $613 billion. In an October report, the IMF predicted that Saudi Arabia’s cash reserves will be depleted in five years if oil prices stay low. At the time oil was close to $50 a barrel.
The problem is that Saudi Arabia is a large welfare state , with the population dependent on direct and indirect government subsidies. Last February (2015), the newly crowned King Salman handed out $32 billion to celebrate his coronation. If oil prices stay low, the country will be faced with the choice of drastic austerity, and severe budget cuts.
In any case, it is unlikely that they will be using their SWF to continue buying global assets – in fact, the opposite is likely.
From net liquidity provider to draining liquidity
Oil-based SWFs, including UAE, Qatar and Russia, have also started to liquidate investments as they try to bridge the gap between low revenues and high fiscal spending. Recent reports indicate that SWFs pulled out at least $46.5 billion from asset managers in 2015 alone – a sharp reversal from the approximately $48 billion allocated to asset managers between 2011 and 2014.
Norway’s SWF experienced its biggest loss in four years (-4.9%) in the third quarter of 2015 -dragged down by Chinese equities and Volkswagen AG – compounding Norway’s problems. The fund is mandated to hold about 60 percent in stocks, 35 percent in debt and 5 percent in properties.
The opacity in the manner of how some SWFs operate makes it hard to get exact estimates of their holdings. JP Morgan projects that SWFs will sell about $75 billion in equities this year. Nikolaos Panigirtzoglou, a London-based strategist at J.P. Morgan, estimates :
“With the caveat that these publicly available data represent only a portion of their public equity holdings, we find that SWFs are most overweight Financials and Consumer Discretionary, and most underweight Healthcare, Consumer Staples and Technology. In terms of regional allocation, they appear overweight Europe, Middle East and Africa and Developed Asia and underweight North America and Emerging Asia.”
Just in 2016, we have seen financial stocks in the U.S. and Europe significantly under-performing the broad-based indices. Interestingly, while oil-producers have been net sellers of equities, corporate and agency debt, they have been cumulative buyers of U.S. treasury securities. This puts even further downward pressure on the yield curve, in addition to some of the other factors we discussed in an earlier post .
It is still an open question as to the medium/long-term impact of SWFs selling risky assets across the globe. Oil-based SWF assets are not large relative to the massive assets held by pension funds, endowments, insurers and individuals. If you estimate that approximately 60 percent of oil-based SWF wealth is held in global equities, say $2.4 trillion (60% of $4 trillion), this is only 3.5 percent of global stock market capitalization (about $69 trillion).
Nevertheless, the more important effect may be that a marginal buyer of global risk assets is now a seller. The reversal of petrodollar flows may matter most in terms of market sentiment over the short-term, especially if oil prices continue to remain at depressed levels between $30-$40 a barrel.