Tail Wagging the Dog

Viewpoints

March 24, 2016



Ask many families about their dog and one better sit down for a while. Raves about their smart dogs are more common than many willingly admit. These same dogs only a short while later can be seen in the yard furiously chasing their tail, eager to eventually catch, but not realizing that they are merely pursuing only an extension of itself. The faster they chase, the faster the tail runs until eventually it ends in exhausted frustration that nothing was accomplished.

In another world filled with well-educated acronyms such as PhDs, MBAs, CFAs, the market can behave in much the same way. For instance, market sentiment this year shifted from no support then turned on a dime on February 11 towards unbridled optimism. Crude oil, the U.S. dollar, and risk assets such as high yield, IG corporates, and the S&P 500 have all trended in the one direction since February – higher.

High yield energy credit has returned 4.5% year-to-date but that doesn’t tell the entire story. High yield energy returned a notable -16.8% through February 10 but since has posted an eye-popping 25.5% return through March 22.




Source: Barclys, Bloomberg

Not surprisingly, high yield energy spreads (as measured by option-adjusted spread, or OAS) has a fairly tight correlation to the price of crude oil. Conventional wisdom over the past year posits that sectors outside of commodities can weather the storm as a safe harbor, fairly immune to commodity price swings. What is more surprising is that the high yield ex-energy subset has a slightly higher recent correlation to crude prices than high yield energy credits. What was previously thought to be less affected by commodity prices actually has traded more closely with commodity prices.

Correlation with Crude Price



Source: Barclays


So, which is it? Do crude price swings mean more to sectors outside of energy than the energy sector itself? That is hard to believe. Or are crude prices signaling that the worst is behind and brighter days are ahead in the commodity markets? Anecdotal conversations indeed confirm the belief that crude has bottomed and an economic recovery is afoot, particularly in emerging economies.

It’s quite possibly a head fake. Why? First, crude stocks only continue to climb and Wednesday’s crude inventory report only furthered that movement. Rising inventories are certainly not indicative of excess supply being worked off. Second, and more notable, the crude oil forward curve portends interesting implications. A front end rally likely helps producers by allowing some short-term hedging at slightly higher prices. This potentially reduces incentives to take marginal production offline. Also, the long-end is potentially more concerning as terminal crude prices are actually over $4/bbl lower than at year-end 2015. This should be concerning as it foreshadows even weaker future global economic views than before.

Crude Oil Stocks ex SPR



Source: EIA, Morgan Stanley

Crude Oil Curve Shift


Source: Bloomberg

Contemporaneously, energy defaults continue to rise as the recent crude rally hasn’t alleviated the stress on the underlying businesses. Continuing development of energy defaults appears highly likely. The current rally does not appear to have fundamental support and may very well end in exhaustion. The tail is wagging the dog. Fundamentals eventually prevail and our view is the current optimism is premature.

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