The recent downward acceleration of crude oil prices, culminating in the stunning 48% six-month decline recorded since mid-year, has sent shockwaves through global financial markets these past two weeks. The secondary side effects of the swift drop in crude oil prices are many. The well-publicized year-to-date collapse of the Russian stock market and ruble aside, falling energy sector commodity prices are weighing heavily on anticipated corporate earnings growth within the energy sector, as well as the aggregated earnings of S&P 500 index members entirely. As of Dec. 16, calendar year 2015 consensus energy sector earnings have fallen by $13.48 since June 30, or 26.2% to $37.91, while next year’s expected S&P 500 earnings have declined $4.92, or 3.7%, to 126.93 from $131.85 over the identical time period, according to S&P Capital IQ consensus data. The recent steady drop in anticipated 2015 S&P 500 earnings was likely a contributing factor to corrective stock market price behavior over the past two weeks. While the market marched higher as expected earnings were actually edging lower, at greater than 17-times next year’s expected earnings, the forward 12-month price/earnings ratio started to look a little bit stretched, in our view. As of last Wednesday’s close, the S&P 500 index had corrected to a more moderate 16-X multiple.
Crude oil price weakness also sent tremors thru credit markets these past two weeks as concerns over declining U.S. domestic oil patch revenues, among small to mid-sized exploration & production firms in particular, elevated investor anxiety regarding the debt servicing costs of some firms. Accordingly, as of Dec. 16, the yield-to-worst associated with the S&P U.S. Issued High Yield Corporate Bond Index (SPUSCHY) increased by 86 basis points (bps) to 7.13% from 6.27% just two weeks ago on Dec. 5. Over this same time period the 10-year Treasury yield declined by 24bps to 2.07% from 2.31% (see chart), demonstrating the flight-to-quality trade in the fixed income market in response to credit-risk concerns, in addition to the simultaneous 4.5% drop in the S&P 500 stock index to 1,972.74 from 2,075.37.
Source: S&P Capital IQ and S&P/Dow Jones Indices
At a high overview level the GMI research team sees declining crude oil prices partially as a byproduct of the changing macroeconomic landscape that is occurring in the early stages of financial market normalization. This process is being driven by the significant cumulative improvement in U.S. macroeconomic conditions. Prior repeated rounds of quantitative easing by the Federal Reserve radically expanded the monetary base of the U.S., weakening the foreign exchange value of the dollar, which in turn increased speculative demand for hard assets like gold and crude oil while simultaneously increasing the market price of these commodities denominated in depreciating dollars. Now that the dollar is strengthening in response to a widening of existing and prospective interest rate and GDP growth differential comparisons between the U.S. and major sovereign economies, it is understandable that we are seeing downward pressure on some commodity prices. For our part we agree with our McGraw Hill Financial colleagues at Bentek Energy who foresee West Texas Intermediate crude oil prices averaging $50.65 per barrel in 2015, suggesting that much of the stress that has permeated financial markets in recent weeks may now be discounted in financial markets.
Additionally, from a macroeconomic overview perspective, GMI Research sees declining energy commodity and related end-product prices as a windfall tax cut for U.S. households and global consumers, essentially constituting a form of fiscal stimulus. In coming months, should the U.S. economy continue to build momentum at its current pace of improvement, market participants and Fed policy makers may increasingly acknowledge the economic benefits derived from this stimulus. Accordingly, the crude oil-based tax cut will then join the building list of fundamental factors reinforcing the case for the initiation of next major phase of the unfolding macroeconomic adjustment process, which is the normalization of U.S. monetary policy and selected market-driven interest rates.
Click here to read more in this week's edition of the Lookout Report.