The year 2016 is turning out to be a really bad one for the world economy. This time, the world is suffering from shocks originating from two principal pressure points: oil firstly, and then China. Contrary to opinion, the victims of the oil price rout are not just oil producers like the OPEC nations and Russia. The sufferers of this price plunge actually span the entirety of global markets.
Lower oil prices may be good for consumers and importers alike, but it is a disaster to producers as well as stock and bond market investors – from New York, to London, Norway to Saudi, and Far East Asia. The only dry spots are the oil shorts and inverse ETF traders.
Despite the tumultuous start to the year, data and analysis suggests that the down trend is far from over. There is still ample room for the markets to keep sliding, hence, those that see current market prices as bargain opportunities will be wise to exercise caution and/or patience.
What is the link between plunging oil prices and stock/bond market routs?
The link is high-yield bonds (a.k.a Junk bonds), which also usually serves as bellwether for the stock market. And historically, sell-off activity in the junk bond market is usually followed by sell-off in the stock market.
Junk bond investors are usually part of the first few people to smell looming danger, because of the very nature of their asset class. The junk bond investors are creditors to seemingly riskier businesses, which tend to be among the first victims and signs of economic stress.
When the lenders (bond investors) to the companies start to show nervousness and initiate a sell off of the companies’ debt, the equity owners (stock market) tend to follow. Hence, activity in the high yield debt market kind of precedes the stock market.
According to some estimates, energy companies make up about 20% of the junk bond market.
As a starting point here is the link between the junk bond market (high yield bonds), as signified by the SPDR Barclays high yield bond index and the oil price:
Oil price vs Junk bonds:
As we see in this chart, price activity in the oil market significantly affects the high yield bond market. Looking from the left hand side down to the right hand side of the chart, we see that the oil prices fall is significantly correlated with stress in the junk bond market.
Next, we look at the relationship between the junk bond market and the S&P 500, one of the most closely followed stock market indices in the world.
Junk bonds vs S&P 500:
The chart shows that sell off in the high yield bond market correlates with a sell off in the stock market. There is also the theory that the junk bond market was going through a bubble as a result of the US Fed easing program. Following the hike in rates, a correction ensued.
Next we look at the relationship between junk bonds and the stock markets of emerging economies, starting with the mother of them all: China.
And then Nigeria:
The chart above shows the Nigerian market falling steeply in reaction to the headwinds.
We can say with a measure of assurance that further slides in the junk market will cause the downtrend in the stock markets to continue.
But what do the charts say for the outlook for junk bonds themselves?
As the chart shows, junk bonds have a bearish outlook. Having already broken a support level as shown by the light blue line above, it seems they are headed back to 2008 levels, as investors continue dropping their holdings of high yield bonds.
They’re continuing to sell off because of the outlook for oil.
What then is the outlook for the oil market?
In 2015, oil at $20 sounded crazy. Fast forward to 2016, and it is no longer hard for the mind to accept.
Iran is now re-entering the market as its sanctions are now lifted after it complied with agreements to curb its nuclear activities. It will be interesting to see how the oil market receives Iran (which says it can boost its exports by 500,000 barrels) this week.