The coronavirus is a rare ‘black-swan’ event – an event that is unexpected and unknowable. It was the match that ignited the market tinderbox. The richly valued market was priced to perfection with expectations for another good year in 2020. Those expectations came crashing down as the coronavirus became a national emergency. We collectively, as a society, are choosing to start a recession to slow the spread of the virus.
The problem with this panic is very different from 2008. The cause of the 2008 crisis was rooted in the financial system. If there was a modern crisis designed to be solved by Fed intervention, that was it. While no amount of Fed intervention can stop the spread of the virus, they still have a vital role to play. Sunday’s emergency rate cut to the Fed funds rate along with quantitative easing added to the previously announced rate cut and $1.5 trillion in additional liquidity. The Fed will work to keep the financial plumbing going. If the economic effects of social distancing percolate into the financial sector (and they are likely to) well-calculated Fed intervention will be invaluable.
We continue to add to our shopping list of quality stocks that meet our strict criteria. What we are finding in our search is somewhat surprising. We are not yet finding an abundance of stocks at bargain-basement levels like we did in 2008 and 2011. Many stocks are down 25-35% but are still overpriced. One reason may be that the S&P 500 index is trading at approximately 15x forward earnings compared to 11x at the bottom of the financial crisis.
OIL PRICE WAR ADDS TO ECONOMY’S WOES
By now you have read numerous articles about COVID-19. We don’t see a need to rehash what you’ve already read. Suffice it to say both its short-term and long-term effects are unknowable. The pundits are simply guessing at this point in time. For the record, the consensus expectation is for a mild recession in Q2 and Q3, followed by a sharp snapback in both the economy and stock market later in the year. There is, of course, a chance it will be worse.
We will instead focus on a less covered story – the oil price war between the Saudis and Russia which has caused oil prices to plunge. At the eleventh hour of negotiations with OPEC, Russia refused to cut production in spite of a worldwide oil surplus. This is a strategic campaign by Russia to cripple U.S. shale-oil production in order for Russia to increase its global share. The timing couldn’t be worse – the rest of our economy can’t cushion the blow from energy – it has the coronavirus to contend with. And Russia knows this.
The major U.S. oil producers (Exxon, Chevron) can survive on $30-40 oil (WTI is now priced at about $30/barrel). But smaller operators and frackers need $50-60 oil to remain solvent. As a result, there will be a lot of mergers coming, and many bankruptcies as well. Debt defaults will hurt the banks (which, in part, explains why major banks are trading at financial crisis levels). And oil-related employment is very substantial, even following the large declines of 2015-2016. Many thousands of jobs will be lost. This is a once-in-history demand shock being met by a once-in-a-generation supply shock going the other way.
According to the U.S. Energy Department, “attempts by state actors to manipulate and shock oil markets reinforces the role of the U.S. as a reliable energy supplier to partners and allies around the world.” President Trump is considering federal assistance to the oil and gas industry including adding to the U.S. Strategic Petroleum Reserve.
Many analysts expect a quick resolution to the price war, but we don’t see that happening. Russia wants to bring our energy industry to its knees, and the Saudis will not cut production unilaterally. Instead, plunging oil prices will add to our economy’s woes at a most inopportune time. We will avoid energy stocks for the foreseeable future. The world is awash in oil. Energy stocks may be cheap – but they are likely to get much cheaper.