During the August sell-off, I wrote an article comparing the fears to the 1997-98 crisis that began with the Asian Financial Crisis and low oil prices that led to Russia’s currency devaluation and debt default and the collapse of LTCM. I argued that market conditions had similarities but no crisis was imminent and called a near-term bottom on September 29. This proved correct as US equity markets soon calmed down and rallied back to the highs.
Global equity markets have been falling without interruption since December 30. The selloff catalyzed on January 4, the first day of trading in 2016, when the CSI 300 fell 7%. The Caixin Manufacturing PMI came in at 48.2 (vs 48.9 expected) on January 3 and China implemented a new 7% circuit breaker on January 4. The weak economic data and the new circuit breaker appeared to lure sellers to push the index to trigger the circuit breaker. The circuit breaker was triggered again on January 7 as it appeared to incite investors to sell before trading shuts down for the day. China promptly eliminated the circuit breaker.
Everything is getting soldThis Chinese equities selloff reignited worries of a slowing Chinese economy across the globe. At the same time, crude oil prices took another leg down, reaching $26 on January 20. However, at this point, equity selling is no longer focused on the commodity producers. The NASDAQ Composite fell 11 of the past 14 trading sessions despite low China and oil exposure for its components. Between December 29 and today’s lows, iShares NASDAQ Biotechnology Index (IBB) fell 21.7%. A slow down in China and low oil prices should not affect the probability that biotech companies develop successful pharmaceuticals or the market size of the indications they treat. Even FANG succumbed to selling even though Facebook, Amazon, Netflix, and Google do not operate in China and their revenues should benefit from lower oil prices as consumers gain more earnings power.
Rumors are these liquidations are partly fueled by margin calls and crude oil associated sovereign wealth funds selling their liquid investments to raise cash. This is a bullish sign as this involuntary selling is not a vote that assets are overvalued.
Good news is ignoredOn January 8, the non-farm payrolls report indicated 292,000 jobs were created (vs 203,000 expected) and the unemployment rate was 5.0% (which is often considered full employment). US equities initially rallied but stocks ended the day lower. This is also true at the individual stock level. On January 19, Netflix delivered a favorable quarterly report and rallied 7% after hours but opened 7% lower by morning after equities sold off around the globe overnight. We are in an environment in which good news cannot overcome the negative sentiment.
Is this 1997 or 2008?The revaluation of assets unrelated to China and oil indicate financial stress persists and is causing investors to liquidate assets regardless of their idiosyncratic fundamental stories. Once again, we must ask if the fears associated with China and oil are a harbinger for a repeat of 1997-98—or worse, is this the 2008 crisis all over again?
Lower oil prices are a worry because the plummeting value of oil & gas debt reminds investors of the credit troubles of 2008. Will oil debt defaults scare investors and freeze up credit markets outside the industry?
Oil & gas debt is not the same as subprime mortgagesThe oil & gas debt problem is different from the mortgage problem of 2008. Mortgages have a positive feedback loop: if a house goes into foreclosure, then houses around it will fall in value. Oil companies are negative feedback: if an oil company goes offline, other oil companies will benefit—creating a less systemic environment.
Furthermore, in bankruptcy events, creditors will takeover the equity of operating oil assets, which is different from banks taking over trashed/gutted homes in 2008. Banks also appear to be in front of the story this time: for example, Wells Fargo reported last week it is classifying oil & gas-related loans as late before they are late.
Oil & gas exposure is much smaller than mortgage exposure in 2008| Bank | Oil & gas debt | Portion of loan portfolio | Loan loss reserves |
|---|---|---|---|
| Bank of America (BAC) | $21 billion | 2.4% | 2.3% |
| Citigroup (C) | $20 billion | 3.3% | 3.0% |
| JP Morgan (JPM) | $13 billion | 1.6% | 4.0% |
| Morgan Stanley (MS) | $4 billion | 5.0% | 3.0% |
| PNC Financial (PNC) | $2 billion | 1.3% | 3.0% |
| Wells Fargo (WFC) | $17 billion | 1.9% | 7.0% |
Only a portion of this oil & gas debt is related to upstream E&P firms. For Wells Fargo, half of the $17 billion portfolio is related to E&P firms. One concern specific to Wells Fargo is that most of the $17 billion portfolio is not investment grade. However, the size of the oil & gas loan portfolios are not at the level that will bring down the banks given their higher capital levels today compared to 2008.
Not the elements for systemic crisisTimothy Geithner co-taught the "Global Financial Crisis" course at Yale. I had asked him if he thought oil defaults could lead to systemic crisis and his belief was no: part of the building blocks of a financial crisis is the financial system has to treat an asset as risk free (when it isn’t) and leverage heavily into it and this is not the case with oil debt. He concluded that oil investors will lose money (and they have) but this isn’t a systemic crisis.
On net, I believe low oil prices are better for the global economy—right now consumers are using the savings to pay debt (US consumer loan delinquencies at 1.41% are well below the 15-year average of 2.25%) and this should translate into more purchasing power down the road.
In 1998, low oil prices contributed to Russia’s currency devaluation and default. Russia was hurt fiscally following an expensive war in Chechnya (mirroring today’s Ukraine action and resulting sanctions) but today it has much stronger FX reserves ($368.4 billion), isn’t defending an unrealistic FX peg, and has low debt-to-GDP (22%). The cost of Russian CDS has increased but I believe a Russian default scenario is still a low probability event at this time.
ChinaOn January 18, China reported Q4 GDP growth at 6.8% (vs 6.9% expected). Industrial production was 5.9% (vs 6.0% expected), fixed asset investment was 10.0% (vs 10.2% expected), and retail sales was 11.1% (vs 11.3% expected). All of these numbers were slight misses and many investors even distrust these numbers entirely. However, equity markets in Asia and Europe rallied following the data release. US equity index futures also rallied but US cash equities turned negative over US regular trading hours.
There is no doubt that China’s economy is slowing. But if the number can be believed, at 6.8% growth, China’s economy would be growing by half the size of Russia per year. Slowing growth is part of the plan as the country shifts from an infrastructure investment economy to a consumer driven economy.
A credit crunch in China is certainly possible as debt has ballooned in the country. However, I would argue that China’s protectionist capital controls have created a moat around its banking system, essentially protecting the US banking system from the Chinese banking system. This reduces the possibility of financial system contagion spreading around the globe as it did in 2008 when US and European banks were tied to each other.
One concern to watch is today’s move in the Hong Kong Dollar, a currency that is pegged to the US Dollar. There was a relatively large move in a nearly zero volatility exchange rate. However, many argue this volatility will not go much further because Hong Kong has deep reserves to maintain the peg.
China, such as fewer Apple iPhones and Nike sneakers sold. Coal and steel imports into China have already dropped off and coal debt & equity have already reflected this slowdown—we can look to Arch Coal’s bankruptcy as evidence. Export declines would be a revenue loss for US corporations resulting in an earnings decline but this would not be a 2008-type of systemic financial crisis.
I think there are some similarities to 1997-98, in which a perfect storm of Asian Financial Crisis, low oil prices, Russian devaluation and default, and LTCM converged. However, 1997-98 still was not a 2008-type event and US asset prices recovered relatively quickly to lead to the Dot Com Bubble. I still do not believe current conditions will create the domino effect seen in 1997-98.”
Investors should stay calm until more confirming information emerges. Since the 2008 financial crisis, there have been a number of panics such as Fukushima in 2011, Cyprus in 2013, and Ebola in 2014 that turned out to be short-term pull backs and great buying opportunities.
Are we at a near-term bottom?During the August selloff, the VIX reached 53. So far the VIX has topped out at 32. The S&P 500 has closed below the September 2014 and August 2015 lows (the Ebola panic and the previous China panic), which is a bearish indicator that support is broken. In 1998, the S&P 500 fell 22% from the highs while it is only down 13% now. But there’s no rule that the S&P 500 has to fall a similar amount or the VIX has to exceed 50 to bottom.
I look to how the market trades relative to news. Capitulation is associated with indiscriminate, across the board selling while dismissing positive news. This means investors just want to sell anything regardless of that asset’s relationship to the problem at hand and that urge to sell is so strong that it overcomes any good news related to that asset. We seem to have observed that. Bottoms tend to form when a large volume intraday sell off is bought and results in a positive close. We partially saw this today, but equities did not close positively.
I believe US corporate earnings over the next few weeks will prove better than the currently abysmal expectations. This can relieve the negative sentiment that currently overwhelms the market and enable a short-term rally, particularly in the NASDAQ, which is not heavy with oil & gas E&P names. However, this does not preclude investors to remain vigilant for signs of a new recession.