After several weeks of market volatility driven by COVID-19 and its impacts on global growth, this morning, markets opened sharply lower once again. Continued concerns about the economic implications of further new COVID-19 cases and the accompanying restrictions on activity were compounded by a plunge in oil prices amid a breakdown in production discussions. As of late morning, WTI (West Texas Intermediate) oil dropped to 33 USD and Brent crude oil to 36 USD. Shortly after the open, the S&P 500 fell -7%, triggering an automatic trading halt for 15 minutes. Once trading resumed, the S&P 500 Index and Dow Jones Industrial Average were both down about -6%, and the U.S. 10-year Treasury yield was at 0.5%.
The source of oil volatility was driven by the news that Saudi Arabia will increase production to over 10 million barrels per day in April. This represents around 10% of global supply and is up from 9.7 million barrels per day previously. Saudi Arabia will also offer as much as a 20% discount for buyers. More importantly, this move has broken the Organization of the Petroleum Exporting Countries’ (OPEC’s) cooperation with Russia in recent years to support energy prices by limiting output, and has triggered fears of an oil price war.
Oil prices have already been under pressure due to demand growth concerns from the outbreak of COVID-19 in Europe and the U.S. This surprise break in the cooperation between OPEC and Russia simply added a supply side dimension to this pressure. The current level of 30-40 USD per barrel would imply an operational loss for many high-cost producers around the world, which would eventually reduce supply. This would ultimately bring prices back towards a more sustainable level, which we believe would be around 50-60 USD in the medium term. Nonetheless, the shock could cause the market to remain risk-averse in the near term.
In terms of the economic impact, lower energy prices are problematic for energy companies and commodity-exporting emerging markets. There are those who could potentially benefit from lower energy prices. For instance, the transportation sector could see lower fuel costs, although their concerns right now would be on lower load factors as air travel continues to be undermined by the outbreak. Consumers could also see higher disposable income if their fuel costs are cheaper. Again, the outbreak may weaken demand if people are staying at home. Energy-importing markets with persistent current account deficits, such as India, could also see a smaller import bill, leading to a smaller current account deficit.
Lower energy prices also imply lower inflationary pressure and this would provide more room for central banks to ease monetary policy, not that global central banks need more encouragement to do this, with aggressive rate cuts coming from the U.S. Federal Reserve System and the Bank of Canada last week to protect their economies from weaker growth.
Given the uncertainty surrounding how a combination of COVID-19 and lower energy prices will affect both the economy and markets, portfolio construction is front of mind. To start, it is important to recognize that the sell-off in equities and rally in fixed income has already begun to rebalance portfolios. As such, investors need to think about portfolios as having three parts - protection, income, and risk. Protection can come from things like cash and U.S. Treasuries, although with the current rate backdrop, high quality fixed income no longer offers real income. In order to address this, investors need to embrace core real assets like real estate and infrastructure, which provide credit-like yields and low to no correlation with equities. Finally, investors still need risk assets in their portfolios - within equities and lower-rated credit, we would focus on companies with healthy margins and minimal leverage. In times like these, it is important to avoid trying to predict the future; rather, clients are best served by monitoring the present situation and maintaining composure.