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A lot of people are surprised at how fast the S&P 500 Index rebounded after the initial coronavirus scare while managing to eke out fresh all-time highs.
But what didn’t rebound? Oil prices and Treasury yields, which are dangerously close to fresh 52-week lows. Both are extremely economically sensitive, and both indicate the coronavirus will cause economic harm around the world.
To be fair, there were reasons to be optimistic about stocks before the coronavirus epidemic hit the front pages. Earnings were about to re-accelerate after being mostly flat in 2019, economic statistics were improving and there was no sign of a recession coming, despite the record length of the economic expansion in the U.S. (For more, read: “Don’t worry about an overbought stock market because the Fed is here to help.”)
But if the economy is doing so well, why is the Federal Reserve going full pedal to the metal on its quantitative-easing operations? QE is like pouring electronic dollars into the banking system that can only be accessed by financial institutions. It’s not the only reason for the present bid in the stock market, but it is a big reason (see chart).
The coronavirus scare has somewhat abated, but I do not believe the official Chinese statistics on the number infected and the death toll from the epidemic. There was a massive movement of people out of Wuhan before the quarantine was imposed, including a lot of international travel because of the Chinese holidays. I suspect that the number infected as well as the death toll is significantly higher, which would explain the willingness of the Chinese government to accept only limited help from the U.S. and other governments.
Real-time China indicator
Crude oil CL.1, +0.21% has traded a few ticks below $50 a barrel over the past two weeks but managed to close above that key level most of the time. I think it will take out $50 soon enough and, at a minimum, head toward $42 and perhaps lower if the outbreak is not contained swiftly. China accounts for over 20% of global oil imports — it’s the biggest driver for oil’s price. The second-largest crude oil importer is the U.S., at just over 13%.
It has to be mentioned that SARS, an epidemic in 2002-2003, did show up in China’s economic numbers. It spread in the late-fall and winter months, but it fizzled by spring time. The Wuhan coronavirus seems to be spreading faster than SARS, but that doesn’t mean it won’t follow the same seasonal patterns. Still, with 400 million Chinese under quarantine, the hit to China’s economy and the price of oil, it is only a matter of time.
One dangerous investment category is that of master limited partnerships (MLPs) in the energy sector in the U.S. They tend to lure a lot of retired investors with their very high distribution yields. Some of those investors think, erroneously, that those yields are safe if they come from pipelines or storage facilities. While I am sure they are safer in the aggregate than the distribution yields of MLPs that produce crude oil, I must mention that many saw distribution yield cuts in 2015 because U.S. shale oil production costs are much higher than those of conventional production.A rapidly falling oil price affects oil production volumes.
Crude oil production first peaked at 9.626 million barrels per day in 2015. By the fall of 2016, it had declined to 8.553 million barrels per day. An 11% decline in volume from the 2015 high caused multiple distribution yield cuts as well as some bankruptcies in the MLP space. The same could happen again (see chart).
If the price of crude oil does what it did in 2015 — culminating in the January 2016 low of $26 per barrel — there is substantial downside for the stocks of both integrated energy companies and the more leveraged oil service ones. Both categories were badly underperforming the stock market before the coronavirus hit, and they now seem to be ready to take another leg lower.
There is a secular decline in oil-service stocks that is rather appalling, as horizontal drilling methods allow for significantly more oil to be produced with much smaller numbers of rigs. The PHLX oil service Index OSX, -1.45% is nearly 50% below its early 2009 low, when the S&P 500 SPX, -0.11% hit 666, while the S&P 500 last week hit an all-time high of 3,348. The OSX index is better than 50% below its January 2016 low, when oil hit $26 (see chart).
A base-case target for crude oil is $40 in relatively short order, while the worst-case scenario is a repetition of what happened in 2015.
What about Treasury bonds?
Ten-year U.S. Treasury notes TMUBMUSD10Y, -0.71% were yielding 1.59% at the end of last week, only 16 basis points above last summer’s low of 1.43% and 28 basis points below its all-time intraday low of 1.31%. Depending on how bad this coronavirus scare gets, we may see an inverted yield curve, like we did last summer, as well as new 52-week lows or new all-time lows in Treasury bond yields. Those are completely within reach (see chart).
For now, an inverted Treasury yield curve should be viewed as a temporary scare and not a sign of a coming recession, if the corona virus follows the 2002-2003 SARS spreading pattern. It’s too early to call for negative Treasury yields in the U.S., as they are primarily a function of European Central Bank policy. But some day, we may see U.S. Treasury yields in negative territory because of the willingness of the Federal Reserve to employ unorthodox monetary policy tools in times of crisis. Still, if negative interest rates did not help much in Europe or Japan — and decimated their banking systems as net interest margins contracted — why would they help here?
Ivan Martchev is an investment strategist at institutional money manager Navellier and Associates.