With oil prices continuing to fall, we have been spending an increasing amount of time analyzing and debating the impact of lower energy prices on our portfolios. In the short term our main concern is that we see meaningful contagion, should a sharp and largely unexpected decline in oil prices spill over to equity and credit markets, resulting in a significant “risk-off” event. To some extent we have seen that happen over the last few months, but considering that West Texas Intermediate (WTI) Oil has declined 40% since June 30, the impact on U.S. equities and credit markets has been relatively modest so far.
The closing of a mutual fund last week — Third Avenue’s Focused Credit Fund — received a significant amount of media coverage and has continued to spook the markets this week. But we must be careful not to apply what happened to this specific fund to the broader credit markets. Specific to the Third Avenue fund, it was modest in size and held a significantly greater amount of distressed assets than the vast majority of dedicated high-yield bond funds. So while risks are no doubt elevated, we think the probability of a full-blown credit crisis remains relatively low. But if oil prices fall further from already low levels, the potential for contagion increases.
As asset allocators with a long time horizon (strategic time horizons of 10+ years and tactical horizons of 12 to 18+ months), we usually see lower energy prices as a net positive for riskier assets such as equities and high-yield bonds, particularly for countries that are net importers such as the U.S. and most of developed Europe and Asia. The argument is that gasoline prices act like a consumer tax: when prices decline consumers will spend more, stimulating the economy. Yet the speed of the decline is increasingly concerning, as is the fact that the credit market is structured differently than it was during other periods when oil dropped quickly.
Two of these structural differences in the credit markets concern us. First, dealers are holding significantly less inventory as a percentage of total issuance. This is the result of post-crisis regulation that limits dealers’ ability to be the source of liquidity to the extent they were in the past. Secondly, the credit sector is much more exposed to energy today than in the past. This is the result of the availability of cheap credit over the past several years, combined with expectations that energy prices would remain well above the marginal cost of production.
Despite the recent declines in energy prices, we maintain our modest overweight to equity and high-yield bonds. We believe the higher interest rates offered by high-yield bonds compensate investors for this risk. But we remain focused on this issue and re-evaluate our view daily, given the increased volatility in energy prices and the broader markets.