The global growth slowdown and troubles with oil and commodities
Despite my upbeat view on the U.S., there are considerable headwinds to the global economy. We see this in the nexus of slowdowns in China and Europe and the decline in commodities, gold and oil which intersect with energy high yield bonds in a negative way. Some comments below.
In the United States, there has been a confluence of good events which should serve to support growth. They include good prints on GDP, consumer credit, manufacturing PMIs and capacity utilization as well as on jobs and jobless claims. The numbers sugest a potential to trend above the 2%ish growth that I have been talking about all year. The fly in the ointment is what I would call an oil bust. This is something I see as not temporary but rather as a fundamental change in the oil sector that will reduce investment for many quarters to come.
I expect the capex problems in the oil sector that I have been writing about to take form in Q4 in a way that subtracts a substantial amount from GDP growth in the US. And to the degree we get revisions, we should expect them to be unexpectedly downward. So the print we get in Q4 will not be reflective of the true growth level for the quarter.
The problem is that we are getting to the down side of the $75-80 range for oil that I see as a tipping point for bad outcomes for capex and defaults. As I wrote last week, there are already indications that deepwater and oil sands capex have been cut. And the distress levels are starting to mount in terms of the funding environment.
The International Finance Review indicates that energy companies are now starting to pull high yield deals due to an adverse funding environment. Alon USA Partners was trying to place an 8-year deal with call after three for 7.75% via Goldman. And today this deal got pulled despite lowering the issue size and making the deal a six year deal callable after four years, all changes that are investor friendly. This deal was to re-finance a refinery that Alon purchased from Valero Energy in 2008. And as such, it should be insulated from the oil price decline because refiners have been benefiting from cheaper crude input, with Valero showing a significant increase in Q3 net income when it reported earlier this month.
What the pulling of the Alon Partners deal tells you is that we now have an indiscriminate investor aversion to energy names in the high yield sector. And so I would consider this contagion given that the cyclical dynamics for refining are very different from the exploration and production side of things. Only if we see a generalized decline in U.S. growth, should we expect refining margins to deteriorate since their input prices are now declining.
The perfect storm that we are looking to avoid is where high yield fund redemptions cause funds to sell non-energy bonds in order to raise cash to meet redemptions. That would increase the contagion and would almost certainly draw in the leveraged loan market as well. We are not there yet. But this is how crises occur. And I should note that energy is considered relatively defensive as far as the high yield market goes. So the rapid change in dynamics is a good example of how crises do occur.
Now, the crash in oil has not occurred in isolation. I would go back to early this year when the Chinese began to put paid to their third plenum pledge of rebalancing away from export and industry-heavy growth. The emerging markets mini-crisis in January and February was a direct result of this as commodity prices slumped. Oil did not slump until the summer but it has done so fairly aggressively since then. Moreover, the net long position in oil futures is still fairly large while the flow to net short suggests momentum to the downside despite oil being oversold. So, to the degree we get poor demand or excess supply data going forward, I would expect selling pressure to be sustained.
Today, we got two pieces of data on this front. China lobbed in a 50.0 print on its PMI, a 6-month low and right a t the contraction demarcation divider. This was below expectations. Also below expectations was the 16-month low composite PMI for the eurozone of 51.4. Analysts expected a slight increase in the PMI instead of a slight fall. So these numbers were poor. Moreover, the numbers showed extreme weakness in core Europe, with France at 48.4 and Germany at a 16-month low. So this is not a case of peripheral weakness infecting the core. It is a situation of weakness right at the very core of Euroland.
Now the ECB is preparing to get into the European ABS market to add support to European credit markets. It is only taking on the senior tranches of deals in order to avoid credit risk. But the hope is that doing so will cause private protfolio preferences to shift toward the riskier tranches of the market, bringing their yields down and supporting new issuance that will lead to greater capital investment and employment. I am sceptical that this scheme will work but let’s wait and see. For now, this is the only stimulus I see in Europe. So I think we should expect weakness to continue, somewhat lessened by the decline in oil/gasoline/petrol prices.
Right now China, Japan, and the eurozone are slowing, putting downward pressure on global growth. This is not supportive of commodity prices. And given the broad weakness of commodities, gold, and oil as well as inflation figures, I believe the signal we should be reading here is of demand side weakness globally. If this weakness materializes, the energy high yield volatility will decrease as oil prices remain low. And the potential for a crisis in high yield and leveraged loans would increase.