If you have filled your car up recently you were probably pleasantly surprised by the decline in gasoline prices. Lower prices at the pump have been a direct result of plunging crude prices, something many consumers have been wishing for. Lower prices at the pump put more money directly into consumers’ pockets and theoretically this new found wealth will be put back into our economy through increased consumer spending. Many economists have likened falling gas prices to a tax cut, something the equity markets would surely welcome. So if lower gas prices and more money in the pockets of American consumers is such a positive why has the stock market reacted so negatively?
There are two primary reasons why the market is viewing lower crude prices as a negative. Both reasons are a result of the “energy revolution” that has occurred in the U.S. over the recent years. The United States dependence on foreign energy has been greatly diminished as domestic production has ramped up, so much so that we are now a net exporter. The industry has experienced rapid growth which has contributed to both jobs and GDP. From 2005 to 2012, U.S. employers shed 378,000 jobs, but over the same period, five oil and das sectors – extraction, drilling, operations, pipelines and equipment and manufacturing added a combined 239,000 jobs. As the United States has pulled its way out of the depths of the “Great Recession” many economists agree that we would not be where we are today without the domestic energy sector. As energy prices have fallen both the profitability and in some cases the viability of companies in the sector has been questioned along with the jobs and prosperity it has created. This brings us to the second and potentially bigger problem – the high yield bond market.
The high yield bond market is a nice name for junk bonds; bonds that are lower rated and have a greater risk of default but pay higher yields to compensate investors for this increased level of risk. The high yield bond market has expanded rapidly as investors have stretched for yields in a low rate environment. The energy revolution has been funded largely in the high yield bond market. Energy is by far the largest sector in the high yield bond market. As energy prices have declined, the profitability and even the viability of the companies that have issued these bonds have come into question. The fear is a “Black Swan” event where large scale defaults in the high yield market cause a chain reaction which reverberates through our entire economy. In my opinion, this is not the likely scenario but certainly a possibility and the risk of this scenario occurring increases as energy prices decline. This does not mean that there won’t be problems in the high yield space, I do expect increased defaults and in a recent interview with the Wall Street Journal warned:
“Energy is the largest portion of the high yield space and persistently low oil prices could result in lower bond prices and increased defaults in the space. As investors have stretched for yield, high yield bonds have gained in popularity and yields have decreased. Large scale defaults in the high yield energy area are a major concern as more investors have moved into them and may be over allocated.”
A numbers of outcomes are possible. Oil prices stay low for an extended period of time and this becomes the new normal. Consumers, the largest drivers of the economy through consumption, lead to further positive GDP growth. Oil can continue its downward trend leading to a wave of defaults in the high-yield market thus exacerbating an already volatile sector. Of course, many of the large, integrated energy companies may start to acquire these downtrodden assets for pennies on the dollar. One thing is for certain – when anything moves as much as oil has over the past 5 months, it leads to uncertainty and thus volatility. So what is an investor to do? First, do not react to volatility, trying to time wild swing in the equity market is a losers game. Second, it is a good time to review your portfolio. Is the amount of risk you are taking in line with your risk tolerance? Is the potential return suitable for the level of risk across the investments you own? As I pointed out earlier, I thought there was a disconnect between the risk/reward in the high yield bond market and other high yield investments which is one of the reasons there has been a precipitous drop. Please contact us with any questions or to review your portfolio.