Covenant Weekly Market Synopsis for November 23, 2018

November 26, 2018

In a holiday-shortened week, we diverge from our usual Market Synopsis format to focus on two investment assets making the majority of headlines: equities and crude oil.

Equity Market Update. There was not much to be thankful for last week in the land of risk assets, particularly in the US:

  • S&P 500: -3.8% / -2.74% month-to-date
  • International Developed: -1.1% / -1.05% MTD
  • Emerging Markets: -1.72% / +1.43% MTD

Volatility has increased, but following last week’s decline the S&P 500 is only a touch over a 10% retrenchment and is essentially flat on the year (+0.18% when including dividends). Though the mention of “normal volatility” may appear to be putting lipstick on a pig, thus far equity markets are not a pig that requires lipstick.

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Sources:  Bloomberg and Covenant Investment Research

Bottom Line: As has been remarked previously in the weekly synopsis, the volatility “feels” awful compared to 2017’s tranquil gains of more than 20% and, in general, the majority of the post-Financial Crisis recovery period.  However, from a historical perspective, this type of volatility is not terribly unusual. Going forward we expect volatility to remain elevated as we press further into the latter stages of the business cycle and the Fed attempts to engineer a soft landing for the economy amid protectionist trade actions, fading fiscal stimulus, and tightening monetary policy.

Crude Oil Update. The price of crude oil, whether measured by the cost of Brent or West Texas Intermediate (WTI), has been hammered of late. Since reaching $76.41 per barrel in early October, WTI has plummeted 34% to $50.42 per barrel as of Friday’s market close (Brent is down 32% to $58.80 per barrel). The chart is ugly, but what caused this sudden sell-off and what does the future likely hold for oil prices?

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Sources: Bloomberg and Covenant Investment Research

In short, the market appears oversold with regards to supply and demand fundamentals. However, before touching on the fundamentals, let’s quickly visit the reason for this selloff. The market was bracing for the Iran oil-export sanctions from the Trump Administration to remove as much as 1.7 million barrels per day from the global oil supply in early November. As a result, global crude oil prices rose even as Saudi Arabia and Russia ramped-up production to offset the expected impact from a loss of Iranian oil. However, just before the sanctions were scheduled to take effect, President Trump granted waivers to eight countries allowing them to continue their oil purchases from Iran for 180 days. Suddenly, the market was confronted not with a shortage, but rather an oversupply of crude oil. There were other factors at play (e.g., slowing global economic growth), but by and large the Trump Administration’s about-face on Iran oil-export sanctions transformed the path toward $90+ oil in Q1 2019 into a 2018 oil bear market.

While the waivers created excess short-term supplies, the global market remains susceptible to a negative supply shock as OPEC spare capacity as a percentage of global demand is near an all-time low at 1.5%.

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Furthermore, even with slowing global economic growth, the demand for oil is expected to increase by 1.5mm barrels per day in 2019 (Source: BCA Research). This level of demand is projected to exceed supply by about 1 million barrels per day, leading to a decline in stored oil inventories.

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Source: BCA Research

Bottom Line: Although the long-term path for oil prices appears to be higher based on fundamental supply and demand forecasts, the short-term price will be determined by the upcoming OPEC meeting on December 6th. If the OPEC countries agree to cut production by 1 million or more barrels to offset the additional supply from the Iran-sanction waivers, the price of WTI crude should recover to the mid-$70 per barrel range in the coming months. If, however, OPEC maintains the current production level, crude prices will remain in a bear market unless, or until, there is a supply disruption.

Be well,

Jp.