Monthly economic commentary: February 2016

Market insights

Peter Rawson-Harris, Research Analyst, Macquarie
Monday 07 March 2016

Economic and market highlights

Economics

Australia’s quarterly capital expenditure report, which contains estimates of spending intentions for the coming financial year, provided little evidence that non-mining sectors (besides manufacturing) are filling in the hole left by dramatic cuts to mining capital expenditures. The survey suggests there may be some way to go before the contraction in mining investment troughs. Australian labour force estimates for January reveal a slight bounce in unemployment is now 6.0 per cent, up from 5.8 per cent. The slight increase appears to be caused by poor sample rotation methodology.

Inflation in Japan has vanished, with the National Consumer Price Index (excluding fresh food) at 0 per cent for the last 12 months. More yen weakness will be required. Taking the effects of oil out of the equation, inflation is travelling at 0.7 per cent year-on-year, still well below the Bank of Japan target of 2 per cent. The Japanese economy contracted in the fourth quarter of 2015, growing only 0.4 per cent for the year.

In Europe, inflation remains subdued with the underlying Harmonised Index of Consumer Prices falling from 0.3 per cent year-on-year to -0.2 per cent. Earlier in the month, the European Central Bank (ECB) announced that there is “no limit” to how far the Governing Council will go to deploy easing measures. In Britain, inflation is 0.3 per cent and well below the Bank of England’s inflation target. Debate has continued over Britain’s exit from the European Union, or Brexit. The decision will be going to a referendum on 23rd June. Putting the matter of a Brexit to one side, the fundamentals of the British economy are stronger than those of Europe, based on retail sales, housing, credit growth and employment.

China’s foreign currency reserves continue to decline, with another $US100bn being used to defend the renminbi. There are $US3.2tn of reserves remaining. Policymakers are attempting to tackle the challenging task of liberalising the capital account while implementing capital controls, and maintaining a fixed but adjustable exchange rate. The People’s Bank of China has also cut the required reserve ratio by half a percentage point to 17 per cent to increase cash available to the banking system.

While any deal between OPEC and non-member countries (including Russia) is some time away, discussions in relation to co-ordinated management of the oil supply have begun. Saudi officials have said there will be no deal unless all parties cooperate, while Russia stated separately that they will not artificially control supply, leaving market forces to determine price. Russia and Saudi Arabia subsequently agreed to maintain supply at current levels. The effectiveness of this strategy depends largely on the cooperation of other oil-producing nations not to compensate. Iran may be excused from the deal due to its recent readmission to the market after sanctions were dismantled.

Nonfarm payroll employment in the United States rose by 151,000 in January, which was below consensus. Jobs gains were led by retail trade, food services and health care. Inflation, measured by the headline Personal Consumption Expenditures (PCE) was firmer than expected, accelerating to 1.3 per cent year-on-year. Core PCE was 1.7 per cent year-on-year. Average wages rose by 0.5 per cent versus expectations of 0.3 per cent, which indicates a tightening labour market, which is potentially spilling into broader price inflation.

Bonds

Government bond yields fell across major developed markets in February. A combination of weaker outlook for global economic growth, deteriorating conditions in China, softening inflation in Europe, and a degree of risk aversion as investors move into assets with higher credit quality has seen benchmark government bond yields fall. Yields on US high yield energy bonds also fell as investors started bargain hunting in distressed names.

Equities

Global equities were generally weak in February. The S&P500 finished the month down 0.4 per cent while the Dow Jones Industrial Average gained 0.3 per cent. In Europe, the effect of unconventional monetary policy on equity markets is waning with indices shedding 3.1 per cent in Germany, 1.4 per cent in France, and 4.0 per cent in Spain. Quarterly price returns make for sobering reading, with Germany, France and Spain losing 16.6 per cent, 12.2 per cent and 22.4 per cent respectively. In the United Kingdom, the relative strength of its economy appears to be temporarily allaying market concerns about a potential “Brexit”, with the FTSE100 gaining 0.2 per cent in February.

In Asia, Japanese equities fell despite negative interest rates, with the Nikkei 225 losing 8.5 per cent and India’s Nifty 50 shedding 8.0 per cent. After the market rout of January, China’s Shanghai Composite took stock, managing a modest 1.8 per cent decline.

Currencies

The US dollar index weakened 1.4 per cent in February. This is largely due to the strength of the Japanese yen (+6.8 per cent), Canadian dollar (+3.7 per cent) and Swiss franc (+5.1 per cent), which together comprise 26 per cent of the US dollar index basket. The pound sterling was weak as markets responded to fears of a “Brexit” causing the currency to lose 1.8 per cent over the course of the month. The Australian dollar was slightly positive, gaining 1.0 per cent against the US dollar.

High Yield Credit in the United States

Fortunes of oil producers have changed dramatically since mid-2014, with the oil price falling from over $US100 to around $US30 to $US40 per barrel today. This has meant many small-scale, tight oil producers in the US and Canada are facing much tougher conditions than anticipated. A supply glut has rendered many of the more expensive fields and extraction techniques loss-making, as margins have been compressed by falling revenues and increasing borrowing expenses. With cashflows dwindling, operations have been increasingly funded with debt capital. Over time, demand for capital, increasing risk of default, and diminishing bargaining power of producers has led to higher cost of finance. This reflected in the implied interest rates on US high yield (HY) energy bond indices.

Figure 1 illustrates the spread in basis points between several categories of bond indices and the benchmark US rate. The spread over benchmark for US high yield (HY) energy has widened from under 400 basis points (bps) in January 2014 to almost 2,000 bps today.

Fig 1 Spread to benchmark US yield curve

Source: MWM Research, Bloomberg, February 2016. (OAS: option adjusted spread)

Fig 2 US bond indices versus crude oil

Source: MWM Research, Bloomberg, February 2016

As the slump in oil became a protracted sell-off, investors have responded by reducing exposure to high-cost producers that are struggling to operate profitably. This has led to a corresponding sell-off in HY energy (see figure 3). At the moment, contagion and spillover effects appear to be confined to the most leveraged players, being HY Materials, HY Industrials, and sub-investment grade CCC-rated operators.

Fig 3 US HY bond indices by sector

Source: MWM Research, Bloomberg, February 2016

While there is some evidence that the turmoil in the US HY energy fixed income market is spreading to the investment grade (IG) market, it appears restricted to IG energy. Spreads on corporate IG energy have tracked higher but to a far lesser extent than HY energy. In last 12 months, Corporate IG bonds spreads have rallied in sympathy from 140bps to 220bps- a far cry from the moves lower credit have endured.

Fig 4 US Corporate IG Energy & US HY Energy

Source: MWM Research, Bloomberg, February 2016. (OAS: option adjusted spread)

Fig 5 Corporate IG & US Corporate IG Energy since 2015

Source: MWM Research, Bloomberg, February 2016. (OAS: option adjusted spread)

As credit and monetary conditions tighten, bankruptcies will continue to emerge. However, a wholesale escalation in defaults is more a function of oil price expectations in 2019 and beyond, than today’s spot price. The reason for this is the so-called “wall of maturity”, which refers to the profile of maturing underlying debt issues in the HY energy bond universe. The bulk of US HY energy debt is maturing between 2019 and 2023. For the so-called oil supermajors, repayments are far more closely matched to cashflows, producing a smoother profile.

Fig 6 US energy HY debt maturity profile

Source: MWM Research, Oxford Economics, February 2016

Fig 7 Oil supermajors aggregated debt maturity profile

Source: MWM Research, FactSet, February 2016. Based on ExxonMobil, BP, Royal Dutch Shell, Total and Chevron.

Years of zero interest rate policy in the United States pushed borrowing rates to all-time lows. This prompted the oft-referenced “reach for yield” as lenders sought increasingly creative ways to augment returns when less risky forms of investment failed to pay off. HY energy producers readily took advantage of the situation, financing growth with cheap debt rather than equity, pushing the maturity date of the loans as far into the future as possible. At the same time, producers have also sold forward production from wells using derivatives, guaranteeing a price they will receive on their oil for up to two years. Unfortunately, hedging books are rarely opened for scrutiny by all and sundry, so knowing when hedges are rolling off or resetting is difficult to determine. As hedges roll off, producers will find themselves increasingly exposed to a languishing spot price.

Breakeven oil prices vary drastically. Depending on the location, they can be anywhere between $US40 and $US80 per barrel. Many will be cutting deeply into remaining cash reserves, and those struggling to service interest costs will find their future in the hands of banks and investors.

An important consideration will be the outcome of discussions between lenders and energy companies, which take place in April and October each year. This is an opportunity to recalculate the value of properties that energy companies staked as collateral for their loans.  A key input to these discussions is the oil price over the prior 12 months.  A year ago the twelve month trailing oil price was around US$70 a barrel. This year, lenders will likely calculate collateral values off oil priced at US$35 a barrel - half of what it was 12 months ago. As valuations and cashflows decline, banks will cut the amounts they are willing to lend to the sector.  This will make rolling over loans very problematic, it often results in either no financing leading to bankruptcy, or penalty rates of financing, further weakening free cashflow.

This April should result in a number of the marginal shale oil producers going to the wall - marking the first significant cuts to global production since prices have collapsed.  This should also see the price of oil rise as it responds to the re-balancing and more importantly the change in attitude to speculative outflows becoming inflows again.

While broader credit markets are not immune to a further deterioration in fundamentals, it appears that for now the bulk of bankruptcies are likely to be limited to HY energy, albeit with spreads of related sectors like materials and industrials negatively affected. Perhaps the greatest downside risk is that expectations of global growth, specifically China, dramatically miss the mark, leading to a further widening in spreads, a sell-off in equity markets and increased volatility.

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