Balancing act. Stocks rose yesterday as investors awaited some comforting words from lawmakers on economic stimulus. Oil rallied on news that President Trump may intervene in the spat between energy heavyweights Saudi Arabia and Russia.
N O T E W O R T H Y – SPECIAL EDITION
What happened yesterday:
Yesterday’s market action looked quite subdued relative to the prior several sessions… on the surface. For much of the day yesterday stocks were in rally mode which was led by the tech sector. Earlier in the session indexes fell briefly into the red but ultimately rallied hitting an intraday high late in the session only to sell off slightly into the close. The Dow Jones Industrial average swung more than 1200 points between its low and high of the day. To the relief of many travel-weary investors the end result was positive for stocks, crude oil, and government bonds. There was still plenty going on below the surface and I will address some of those questions below.
Q: What is going on with crude oil, and why is everyone so focused on it? A: First, it is important to note that, despite all of the great efforts to come up with alternative energy sources, crude oil is still the king of energy. The world still relies on crude oil not only as the basis for things like gasoline, jet fuel, and heating oil, but also for plastics, nylon, industrial lubricants, and asphalt. So you can see that virtually all sectors rely on crude oil in some way. There is a saying that money is the oil of industry, which is true (as we have seen in the past few weeks), but I also like to say that oil is the oil of industry. While there is much talk about the reduced power of OPEC+ in price fixing, they still produce quite a bit of the world’s supply. Saudi Arabia and Russia (the + in OPEC+) alone produce 23% of the global supply. A spat between those countries, number 2 and 3 behind the US in production, led to the precipitous slide in crude oil over the past weeks. Saudi Arabia bumped up production and offered discounts in a time where demand for product is dropping. Supply up and demand down means lower prices… much lower prices. The Saudis hope to punish Russia and shake out other producers like the US by intentionally causing a price drop. The drop in price also affected the already shaky energy sector which has been in a state of transition. Energy stocks make up 5% of the S&P500 and the sector accounts for about 7% of US GDP. Let’s also recall that it was the emergence of US shale oil industry that spurred job growth helping the US economy out of its last slump. So when oil suffers, the market suffers. As a result of the price war between the Saudis and Russia, crude oil sank to its lowest levels since 2002. Yesterday, the Administration announced that it would increase its purchases of crude for the strategic oil reserve and that it is considering intervening in the row between the OPEC+ giants. The news helped push crude oil prices up by +23.81%, its largest single day gain… on record.
Q: With all of this turmoil, will my money be safe in money market funds? A: Money market funds are the go-to instrument for investors who wish to stay in cash. They provide interest when possible, same day cash availability, and always return investors’ capital. You may recall that during the financial crisis some higher risk money market funds “broke the buck”, which means that some investors were unable to get back all the money they put in. The cause of that event was the collapse and seizing up of the banking sector in the wake of the Lehman and Bear Stearns collapse. Investors rushed in to redeem their money markets and fund managers needed to sell the high quality bonds which they hold. With the markets in disarray they were unable to sell efficiently causing a few of the riskier funds to break the buck. Today’s financial system is very different with many more regulations in place designed to protect against those types of events. More importantly the banking sector is very strong with plenty of liquidity. The Federal Reserve has seen to it that banks are flush with capital to address the needs of businesses and consumers. Yesterday, the Fed also announced that it would launch the Money Market Mutual Fund Liquidity Facility which would provide dealers with special financing to purchase securities from money market providers. The move gets ahead of any potential liquidity issues that may be caused by increased redemptions, further strengthening the money markets.
Q: What is happening with bonds, I thought they were supposed to be stable. A: Not all bonds are created equally. US Treasury Bonds are the safest global fixed income investment. That means that the bonds are backed by the full faith and credit of the US Government. Because of that you can expect that you will always get your interest payments and you will get your principal back at maturity. Because they have such a low risk they don’t pay a big return… and that low return has gotten lower and lower in the past 30 years with both the 10-year note and 30-year bonds hitting all-time low yields below 1% just recently. This decline in return has pushed many bond buyers into riskier bonds in search of more yield. The demand for high quality corporate backed bonds have pushed prices up and yields down bringing spreads to historic lows. That means that the amount of extra return you get for taking on the additional risk is really small. This has caused many investors to go further up the risk ladder into junk bonds, which are bb rated and lower. These bonds are often issued by riskier companies and are not backed with any collateral. These companies have a higher probability of defaulting if things get tough. As many investors are now anticipating an economic slowdown over the next 2 quarters they are selling lower-rated bonds and avoiding them altogether. This has caused price drops in not only high yield bonds but also ones that are on the cusp of high yield ratings like bbb. This has pushed spreads and yields up but investors fearful of a rating downgrade have been reluctant to dive in. Rightly so. Lower rated bonds trade more like stocks than bonds and just like with stocks a little bit of patience is the prescription in these markets. As guidance becomes more firm and a clearer picture about the economy emerges, those buying opportunities will come… they are not here just yet.
– The National Association of Realtors will release its Existing Home Sales figures for February which are expect to show a growth of +0.9% compared to January’s decline of -1.3%.
– Next week we will get some preliminary manufacturing figures for March, additional housing numbers, GDP (Q4), preliminary sentiment figures for March, and many more. The March figures will start to give us a better understanding of the real effect of the Coronavirus on the economy. Check back on Monday for weekly calendars and details.