Update on Financial Markets

  • 12 March 2020
  • 15 mins reading time

• An already stressed situation has been made more acute by tumbling oil prices

• There are echoes of the double-whammy situation we experienced in 2015

• We remain optimistic that a co-ordinated global response will allow this to be a relatively short-term situation

First things first

As the chart demonstrates, we have seen financially stressful situations many times before, and we fully expect to encounter more in the future. We are making short-term tactical adjustments designed to offset some of the asset price turbulence that we’re currently seeing, but our focus is on the long term which, we believe, provides the best approach to returning positive performance and avoiding snap judgements that could feel reassuring at the time only to prove costly in the future.

It is with this over-arching investment philosophy and sense of calm that we consider the current economic situation.

The coronavirus crisis

The coronavirus COVID-19 continues to spread across the globe. At the time of writing there were over 120,000 confirmed cases with more than 4,300 fatalities[1]. Unlike coronavirus SARS, COVID-19 is contagious before it can be diagnosed. That is creating a contagion rate that demands serious measures.

Italy has followed the Chinese example of restricting the movement of its citizens in. This has led to an effective lock-down being imposed across much of the country. The slower the contagion rate, the greater the chances medical services have of coping with the influx of victims and the more time is bought for pharmaceutical institutions to develop a cure or a vaccine.

Inevitably, if the movement of people is restricted, then production, sales, delivery and life in general is curtailed. As investors, we have to be aware of the broader economic implications. While we currently foresee these implications as being relatively short-lived, they are severe.

Economic implications

The Organisation for Economic Co-operation and Development has estimated that global economic growth for 2020 will be cut from its November prediction of 2.9% to 2.4%, while rating agency Moody’s is predicting 2.1%.

It will take an unknowable number of months before we have appropriate medicine to tackle the virus. In the meantime, the global economy remains vulnerable to other shocks.

Unfortunately, an entirely unrelated further shock has occurred: the price of oil has plummeted.

The additional shock

A couple of months ago, a barrel of Brent crude oil would have cost just shy of $70. The price has been declining slowly but steadily since then as the projected demand for oil was adjusted down to allow for the ramifications of COVID-19.

Then, over the weekend, Saudi Arabia announced that it would increase the supply of oil substantially. That sent the price down to $33 a barrel.

The Saudi Arabians took this decision after failing to agree a cut in production with other oil-producing nations, notably Russia. The intention had been to reduce the overall supply of oil and, thereby, push the price of oil up. If a group of oil-producing nations do this together, then they all benefit from a higher price of oil. This also would have provided some oil price stability which is beneficial to the broader financial markets.

If one country goes alone then it loses out on sales, while other countries benefit from the higher price of oil. On realising that other nations would not comply with a cut in oil production, the Saudi Arabians decided to exert pressure on other oil-producing nations by increasing the supply of oil and sending the price down.

Aramco, the huge state-owned Saudi Arabian oil producing company, can produce oil at a cost of $2.80 per barrel[2]. For offshore and shale oil producers, the production cost is anything from $40 per barrel upwards. Clearly, the recent price slump leaves most non-Saudi oil companies under huge pressure. UK corporate giant, BP, saw its share price fall by almost 20% on Monday 9 March. It was representative of oil companies’ share prices the world over.

But there are secondary implications that send tremors across investment markets beyond oil companies.

Oil waves

North American shale-oil producing companies have sold or “issued” billions of dollars-worth of bonds to fund their operations. That leaves those companies with debt obligations that they have to meet no matter what’s happening to their profit levels or share prices.

If such a huge volume of bonds appear to have become at more risk of payments not being made then holders of those bonds would have good reason to sell. But who’s going to buy those bonds or the oil companies’ shares under these circumstances?

That combination of falling prices and lack of demand creates a problem for financial and other institutions that need to sell some assets from time to time to provide sufficient cash for their day-to-day operations. It leaves them having to sell some of the other assets that they hold which, in turn, pushes the prices of those assets down as well.

It’s that sequence of worry that the tumbling price of oil has triggered. But it has done so in an already distressed environment. That’s why such a broad range of stocks has fallen so sharply in recent days.

The prognosis

We currently face an ongoing crisis with COVID-19 as well as the more immediate oil-related situation.

Our position on COVID-19 is that there will be more infections and fatalities, and more actions to try to stem contagion until a cure and vaccine are produced. This is going to take an unknowable number of months and will have a negative effect on economic growth. While it could still be a relatively short-lived phenomenon, there is no instant solution.

The oil scenario has a different profile. If oil-producing nations can work together, then we could see the Saudis retract their increased oil production numbers in an instant.

Looks familiar?

There are parallels with the double-whammy we faced in 2015.

Back then, we had a situation in which global economic growth was waning. China’s ability to continue driving global economic growth was dissipating. As a result, the demand for and prices of a broad range of commodities was declining. Not least of these was oil.

Then the Chinese devalued their currency. This was done, at least in part, to help stimulate Chinese exports and support the country’s economic growth targets.

But this was hugely destabilising for the rest of the world’s national economies. It came with no warning, appeared to indicate a pattern of unilaterally minded financial policies, and undermined the export outlook for non-Chinese companies.

In other words, we had a combination of a gradually worsening situation exacerbated by a sudden shock.

What could happen?

In 2016, the Chinese currency devaluation was countered by a sharp injection of capital by the Chinese authorities as well as a more transparent approach to currency management. That helped to reassure international market participants, allowing the prices of oil and company shares to recover.

A similar pattern is possible today.

Taking the oil situation first, the pressure that is being exerted on US, European and Russian producers is severe, so we would not be surprised to see some sort of rapprochement. If that were to happen, we could see a climb in the price of oil and a reversal of some of the more severe knock-on effects that followed the oil price slump.

Meanwhile, the virus situation is going to take some months to run its course.

While that happens, we anticipate governments and central banks making a co-ordinated response to ensure that the supply of money is reasonably plentiful. In other words, interest rates will be lowered where possible, quantitative easing could be increased and government spending could go up. We have already seen substantial interest rate cuts implemented at short notice by the central banks of a number of countries including the US and the UK.

The big question

What we really want to know is how long the implications of this combined whammy will last.

The sooner the oil situation is resolved, the more limited the losses will be. And if a vaccine or cure can be found, the money pent up by the postponement of buying holidays, cars and carpets could be released fairly quickly.

For now, we are optimistic that the effects will be relatively short-lived, if severe, and that the permanent damage to economic growth will be limited.

But this is the qualification. Unlike 2016, the situation we face today is global. As such, it requires a global and co-ordinated response. That is what the Saudis are effectively demanding for oil supplies, and it’s what’s required to combat the spread of COVID-19. The central banks are making it clear that they’re on the case. So now we turn to the politicians.

[1] Source: WorldofMeters.com [2] “Oil price war is a nightmare for US shale producers”, Al Jazeera, 9 March 2020.

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