What are the important trends developing underneath the surface in equity markets?
Our Top Market Takeaways for April 21, 2020.
A sign of the times
West Texas Intermediate (WTI) crude oil prices went negative for the first time ever, trading between $0 and -$40 per barrel yesterday afternoon.
How is that possible?
Let’s say you own a May contract for WTI crude. That means you bought the right to be delivered an actual barrel full of oil in May. You bought it at ~$20 in the hope you could sell it for more than that.
But…given the COVID pandemic, demand for crude has plummeted. No one needs or wants oil right now, so the price of oil keeps going down. Today marks the last day you can get out of the contract, and you don’t want to—or aren’t equipped to—accept a delivery of physical oil. You probably have nowhere to put it!
With time short, you need to get out of that contract now so you don’t have to deal with an actual barrel full of oil come May. Negative prices mean you are actually paying the person with the oil to not give you the oil.
Why hasn’t this happened before? Most of the time there are people out there who actually have the logistical and physical capabilities to buy extra oil and store it until they can sell it for a profit. This time, apparently, there’s so much unused oil already in storage that there isn’t enough room to store the oil they’d receive from the contracts expiring today. Hence, the downward pressure from people doing anything to get out of receiving actual oil.
There are two remedies to this. The first is that there needs to be less oil in the world. Production needs to come offline to help balance supply with demand. OPEC+ producers made a start at this with production cuts announced the other week. Second, demand needs to rise, which will likely happen once travel and work restrictions are lifted as economies attempt to reopen. However, the financial ramifications of a negative price of WTI crude at the expiration of a monthly contract will only be fully known in hindsight.
It is also important to note that prices for WTI crude at every other point of the futures curve are still in positive territory. This suggests that most of the disruption is focused on the very near term. However, if producers keep pumping oil out of the ground, and travel continues to be restricted, we could see more contracts go negative at some point in the future.
Other risk markets, like equities and high yield debt, actually fared well, given the circumstances. The S&P 500 was down -1.8%, and the energy sector was actually not the worst-performing sector on the day (that title would go to utilities, followed by real estate). In fact, the Oil and Gas Exploration and Production Index was actually up 1.5%, boosted by higher natural gas prices. Healthcare and communication services were the best S&P 500 sectors yesterday, each down less than 1%.
So far today, markets are still working to digest the news. Most global stock indices are trading lower. Outside of crude dynamics and the path of the virus, investors will have their eyes on Washington as Congress looks to pass a bill that replenishes the Payroll Protection Program and allocates funding for coronavirus testing and hospitals.
Everyone is adjusting to the post-COVID world, and markets are volatile because they are constantly trying to incorporate all the new information they can. However, when you consider a longer time horizon, you can start to see some important trends that are developing beneath the surface.
What are equity investors thinking?
What are equity investors thinking? On one hand, it seems to be well understood that at this point there will be no quick return to “normal". On the other, the S&P 500 has already recovered 50% of the COVID sell-off. Are markets holding out hope for a silver bullet? Are they completely ignoring the risk of a second wave? The IMF thinks the COVID-19 shock is going to cause the deepest growth shock since the Great Depression! How can the S&P 500 only be 15% below its all-time high?
It seems hard to reconcile the “risk on” price action of the last month with the evidence that the COVID shock will lead to lasting damage and will likely lead to some changes in the way the world operates. However, when you sift through the differences in performance by characteristics and exposures, you get some clues as to what the market is thinking. To us, it seems like the market understands the lasting damage, and is starting to differentiate between the companies that can survive the disruption and benefit from the new normal, and those that face material challenges.
A simple look at sector performance helps to illustrate this. Healthcare (-2.0%) and information technology (-4.2%) are the two best-performing sectors so far this year. Energy (-44.9%) and financials (-28.6%) are the worst. It is easy to understand why the healthcare sector would be able to hold up during a pandemic, and businesses and households are wholeheartedly embracing digital solutions to the problems caused by physical distancing. In fact, you could make an argument that a prolonged period of physical distancing could actually support some parts of the technology complex.
On the other side, no one is traveling anywhere by any method. The International Energy Agency (IEA) expects that oil demand in April 2020 will fall to 1995 levels. As is apparent from the first section of this note, if you are in the business of finding and selling oil, these are difficult times, and there doesn’t seem to be a quick path back to where we were a year ago.
Financials are also challenged. They are broadly in the business of lending money to consumers and businesses. Right now, given widespread lockdowns and rapidly rising unemployment, those consumers and businesses are much less likely to pay the loans back, and low interest rates and a flat yield curve reduce bank margins.
Consider what the companies that investors have preferred through the sell-off actually do:
- Develop treatments for COVID-19
- Sell stuff you buy at the grocery store
- Design software for remote work platforms
- Deliver anything you want to your house
- Stream original and existing content to your living room
Now, these are what some of the businesses that investors have shunned do:
- Run cruises
- Find and sell crude oil
- Fly people around the country and world on planes
- Sell clothing in brick and mortar stores
- Operate sit-down casual dining chains
Differences are also apparent when you break it down by size and styles. Small cap stocks in the United States are down 27% year-to-date, drastically underperforming large cap stocks. This could suggest that investors believe large and mega-cap companies have a decided advantage in not only surviving the turmoil, but also in gaining market share from smaller players. The most indebted companies have underperformed the least indebted companies by over 20%.
One solace for index investors is that the most impacted sectors make up a relatively small share of market capitalization and earnings. Technology and healthcare make up 40% of the S&P 500, while financials and energy make up ~13%. The energy sector made up a little less than 4% of the S&P 500’s earnings last year. Airlines are another example. Based on data from FactSet, the Global Airline industry has a market cap of ~$188 billion. Netflix alone has a market cap of $191 billion.
Likewise, investors are differentiating between the countries that are better positioned to recover from this shock, either because of relatively successful containment efforts, the ability to deficit spend without excess risk of higher borrowing costs and inflation, a high weighting toward technology, or a combination of the three (we’d point out New Zealand, Denmark, China, Taiwan, Switzerland, the United States and Korea). On the other side, the countries that are furthest from their recent highs tend to not have the ability to issue debt in their own currencies (Brazil, Colombia, Chile, Greece, Mexico), or have a heavy weighting toward energy and financials in their equity indices (Austria, Russia).
Even if the market is doing a reasonable job at discerning the winners from the losers, there are reasons to approach the stock market as a whole with caution. The S&P 500 has gotten even more concentrated at the top (the five-largest companies in the S&P 500 now make up nearly 20% of the index by market cap, compared to roughly 13% at the start of 2017), and things were already stretched at the beginning of this year. Just because investors may be rewarding the companies they think can adapt to the eventual new normal doesn’t mean they will actually be able to meet and exceed expectations. On the other side, value may emerge in certain sectors if and when the market goes too far to price in material weakness.
In the end, it comes down to a simple equation: expected company earnings multiplied by the price investors are willing to pay for those earnings. Last week, we explained why we think we are close to the top end of a realistic range for the market as a whole. Remember, 2,800 on the S&P 500 is about $165 of earnings per share (2019 levels) multiplied by a forward P/E ratio of 17x (above historical averages). While the index as a whole will likely be constrained by this dynamic, it seems likely investors will continue to split companies into those that can survive (and even thrive) as we work toward the new normal, and those that can’t.
All market and economic data as of April 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.
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