God knows there’s been no shortage of discussion this week about the “oil spill.”
Both WTI and Brent are headed for their 5th weekly drop after crashing into a bear market earlier this week.
“It’s becoming bearish mania,” Phil Flynn, senior market analyst at Price Futures Group Inc. in Chicago said on Friday.
Yes it has. And if this is, as some commentators have described it, a “perfect storm,” then it’s one that everyone should have seen coming, because it’s been abundantly clear for months that balancing this market isn’t an overnight project.
Now you’ve got Libya producing at its highest rate in four years, which only adds to the trepidation over US supply and the crisis in Qatar has seemingly done more to stoke fears about the viability of the production cut deal than it has to embed a geopolitical risk premium in prices. Meanwhile, oil rigs in the US gained for 23rd week in a row, Baker Hughes reported a few minutes ago.
Of course one of the big questions this raises is what it portends for a high yield space where spreads have compressed mightily over the past year mirroring the rally in anything that can be described as “risk.”
So far, so good, in terms of widening in energy spreads not spilling over into HY more broadly, but a whole lot of folks are starting to ask how sustainable that state of affairs is – especially given energy’s representation (right pane):
More generally, an environment devoid of catalysts enhances the extent to which anything off-kilter gets magnified (and in this case, that’s an especially salient point given that the plunge in crude prices comes against a backdrop that finds DM central bankers still struggling to move the needle on inflation).
With all of that in mind, consider SocGen’s latest fixed income weekly piece excerpted below…
Watch out for oil spills
There’s barely anything going on. No more political contests, no Fed or ECB meetings, no earnings season to derail the markets. The only events this week were the results of the second round of the legislative elections in France and the beginning of the Brexit negotiations between Messrs Davis and Bernier. Both events were widely anticipated so the impact on the credit markets was nil, although they did make for lots of headlines.
But then the market, with nothing else to do, started to focus on oil prices. They had been falling for a while (having started the year near the $55/bbl mark) but this week the drop accelerated, nearing the $40/bbl level. And this matters, as previously we spotted a correlation between falling oil prices and wider spreads (via the US HY energy sector in particular). And this correlation strengthens when oil prices fall below $40/bbl. Furthermore, as our Utilities analysts Paul Vickars has highlighted, $40/bbl is the breakeven level for several European oil companies and clearly a drop below those levels would not be a welcome development at all.
We still think we are set to have a calm summer with spreads (cash and synthetics) moving in a narrow range, with a gentle tilt towards tighter and tighter levels. After all, oil prices have stabilised recently and it is not clear that they will fall further. Moreover, we’ve already seen spreads improving slowly as cash is close to the tightest levels of the year, and iTraxx indices did set the tightest levels of the year on almost a daily basis this week.
As we stated above, this is likely to push credit curves to flatten as the long end outperforms. The 10y+ tenor has widened this year but is coming back as sovereign yields are not only not rising, but have fallen from the higher levels seen earlier in 1Q.
In our view, the higher beta sectors that we like very much (AT1 CoCos, Sub insurance, Tier 2 bonds, Corporate Hybrids) should continue to outperform the rest of the market through the summer even if oil prices suffer, although we note that if that happens, the hybrids of some oil companies will undoubtedly weigh on the sector’s performance. Still, we see them as the best alternatives in a world in which yields seem to be stuck at very low levels and are likely to stay there for a very long time.
HY is a more complex proposition. This week we discussed how when we look at the riskadjusted yield HY looks much more attractive than when we look at the absolute yield levels. And only last week we argued that in the current environment, although very expensive in absolute or relative basis, the hunt for yield means that HY is likely to remain at current levels and even tighten further. But the drop in oil poses a stern challenge for the HY market. In the US, the energy sector is still large in the HY market, and US HY has already started widening (+13bp since the better levels of last week). The move is still mild but if oil prices fall further, we expect US HY to come under more pressure and eventually this should feed into euro HY. To us, this is another argument to stick to the higher beta IG sectors.