You wouldn’t know it on the basis of the strong US market action January 26, but it wasn’t all quiet in overnight trading.
Local markets in China (FXI) took another hit, with Shanghai and Shenzhen exchanges experiencing declines to the magnitude of 6%-7%+ on the session. Though some optimistically dismiss the local China markets as irrelevant, the implications on weakened Chinese banks, other Asian nations via trade, and interconnected financial institutions from Standard Charted to HSBC (HSBC) and even Citigroup (C) are material, in our view, and we’re paying close attention. Some may even say that China stocks represent less than 15% of household financial assets in the country — certainly not enough to cause a global calamity…
Or is it?
What observers may be forgetting is that US exchanges in the 1920s, for example, were also highly-unregulated prior to Glass-Steagall, and while literature will tell you that “everyone was in the market” back then, only about 2% of the US population had meaningful savings tied up in equities in the mid-1920s and about 16% at the market peak in 1929. In an environment where commodity prices are flailing, steel mills reeling, tourism facing pressure, and wealth tied up in Chinese markets evaporating, the combination may explain why growth in the country has slowed to its lowest level in 25 years. Whatever your opinion, we don’t think the collapse in local Chinese markets can be ignored, especially if history is any guide.
Of course, China is not the only country facing troubles. The “B” in the “BRIC” nations, Brazil (EWZ), is arguably headed for its worst recession since 1901 (not a typo), as many are targeting the country’s GDP to shrink as much as 3% this year amid surging inflation. Shares in Brazilian equities have effectively collapsed, with Petrobras (PBR) being perhaps the best illustration of the rise-and-fall of the country’s economic hope, as of late. The Brazilian oil giant’s shares, for example, once exchanged hands near $40 and now are trading for just a few dollars each. Shattered consumer confidence and political unrest will keep any sort of recovery in Brazil a number of years away, at least. Having the Olympics in Rio de Janeiro could leave the country with overcapacity for years to come, arguably at the worst possible time.
The pain doesn’t end there though. Recent measures of economic growth in Canada (EWC) have improved, but the country had been in recession for most of 2015, and slightly improved energy resource pricing may not spell “escape velocity” when it comes to sustained economic growth in the country. In fact, most economists believe that Canada may have never escaped recession at all in the back half of 2015, and most fear that rising oil output, which will have implications on the supply of crude oil altogether, not the least of which is its price, may be the only way to pull the country out of the doldrums. Darned if it produces more (lower energy resource prices), and darned if it doesn’t (recession) — the ongoing sources of continued global oil “oversupply” remain many and varied.
Though member nations of OPEC, including Ecuador (ILF) and Venezuela, continue to request emergency meetings, we believe the largest cartel participants, including Saudi Arabia, remain as dedicated as ever to production levels in an ongoing strategy of “market share retention” as opposed to “price stability.” The strongest OPEC members have had years to scale back production, and the latest pleas from weaker nations won’t do much, in our view. For one, the cartel could have reduced plans for supply as recently as December 4, and a break-up of the cartel would only do more damage. Political tensions between Saudi Arabia and Iran could bring more barrels to market, and many US independents may not have a choice but to keep producing (and cash flowing) in this low-price environment to avoid committing “economic suicide” as bank lines and creditors tighten the noose.
Distribution cuts across the upstream MLP (AMLP) space have become commonplace. From Linn Energy (LINE) to Legacy Reserves (LGCY) to EV Energy Partners (EVEP), the very idea of whether an upstream company can handle the MLP business model has simply been thrown out the window. Even midstream MLPs are having a difficult time paying distributions, as Boardwalk Pipeline (BWP) can attest, and Kinder Morgan (KMI) transitioning to a corporate did little to stem the dividend cut that was eventually to come. Among producers, banks continue to cut credit facilities across most of the weakest credits, including Laredo Petroleum (LPI), Oasis Petroleum (OAS), Whiting Petroleum (WLL), Denbury Resources (DNR), Energen Corp (EGN), and SM Energy (SM).
On January 25, S&P downgraded Chesapeake Energy (CHK) to CCC+ from B with a negative outlook, all but spelling disaster at the company. Chesapeake’s credit rating was just BB- a few weeks ago, revealing how fast credit conditions can deteriorate. Last week, Moody’s recently placed a swath of energy companies under review for widespread downgrades, “Moody’s Puts Oil & Gas and Mining Sectors on Review,” and we expect some multi-notch downgrades when all is said and done. In late 2015, Swift Energy (SFY) became the ~40th North American upstream player to encounter a credit event during this downturn, and we doubt it will be the last. The credit rating agencies expect energy defaults to surge in coming years as the industry seeks to roll over a half-trillion ($500,000,000,000). As contracts can be broken under Chapter 11 protection, we do not believe midstream companies to emerge unscathed.
If that’s not at all troubling, currencies of commodity-exporting countries continue to reel. Assets continue to flock to US government bonds, with emerging market currencies taking the worst of it. Just last week, for example, South Africa’s (EZA) rand fell to the lowest levels against the US dollar in more than seven years. On January 25, the Columbian (ICOL) peso hit a record low against the US dollar, the Russian (RSX) ruble hit its lowest level against the dollar, and now it takes as much as ~C$1.40 to buy one US dollar. It wasn’t but a few years ago that the Canadian and US dollars were at parity. The dollar strengthening relative to the currencies of commodity-exporting nations will remain a key theme.
The global financial system has advanced considerably since the doldrums of the Great Depression, and more recently, the Great Recession, but slowing growth may be all that is needed to continue to ratchet down forward earnings estimates, and that means lower stock prices. According to the latest reading, the S&P 500 (SPY) continues to trade a forward multiple that is greater than its 10-year forward average, and the risk to earnings estimates in light of troubling global economic conditions remains to the downside. We continue to remind investors that the S&P 500 has effectively tripled from the March 2009 panic bottom, and the recent drop to begin 2016 may be just the beginning of something deeper. We continue to cast a cautious eye on this market, even as we look to bring new ideas to the newsletter portfolios.