Oil price and bond yield moves cause stock market roller coaster

10 June 2016

Having reported last week about a good start to June after a decent month of May, the end of the past week brought us the opposite. A reminder of the nervous side of current capital markets. The week ended with an up to 2.5% sell-off in the main stock markets because - well, once again, not very much.

Until Wednesday a rising oil price which finally seemed to establish itself above the $50/bbl mark, appeared to fuel equity markets. The US stock market as represented by the S&P500 (large company) stock market index even came within touching distance of last year's all-time high. Then the wind turned, when the start of the long announced corporate bond buying program of the European central bank (ECB) pushed long term bond yields lower and thereby bond prices upwards - not just in the Eurozone.

At the same time the oil price retreated once again below $50/bbl, as the latest US oil rig count showed another increase. This trend has the potential to increase US oil output again after the lower prices had previously led to large scale closures and thereby supply capacity reductions. Both, the rising bond prices and the apparent ceiling of $50 for the oil price must have driven home the message to speculative, short term investors that 2016 really is not a repeat of the market actions of 2015.

Last year the oil price rose back to $60 and bonds experienced a sharp sell-off when yields recovered from their Q1 lows (see charts below). This year bond yields are not recovering as they did last year between May and August because the ECB has just increased its QE buying volumes. Likewise, the oil price is not rising as much again because the supply metrics appear to have changed permanently. It was therefore perhaps not overly surprising that the '˜fast money' rushed from the stock markets across to the bond markets to take advantage from the upside momentum the ECB bond buying created.

This does not necessarily mean a reversal of the direction of the stock markets, but it does once again show how little it takes at the moment to cause a sudden, sharp selloff.

The coming week will have many more economic data releases to provide new direction and the most important event will be the US central bank's rate setting committee (FOMC) meeting, or rather the press conference afterwards. There is now a fairly broad expectation that the US Fed will not raise rates this month, but strongly hint that they will do so next month, barring any unforeseen events.

The biggest potential '˜event' will be the outcome of the UK's EU referendum on 23 June. The big debate about potential economic and capital market consequences of a Brexit has now reached the Global level. Interestingly there are a number of reputable sources which suggest that given the '˜divorce' process would be quite lengthy, not much economic contraction would need to occur this year. I am not convinced and suspect that this may well have been a general reassurance attempt in response to recent online opinion polls results suggesting the outcome is too close to call.

I would agree that during the initial course of Brexit preparations no specific changes to trade agreements would come into force and therefore little impact should be felt by the real economy. Unfortunately though, changes in economic activity levels are oftentimes driven more by changes in expectations than the actual status quo. Furthermore, capital markets are bound to react negatively to a Brexit majority vote, because it would come as a surprise to them - i.e. they are not pricing it in because they take their clues from the betting odds rather than opinion polls. Here, the recent upswing for the '˜Leave' campaign momentum following the release of latest immigration figures had a much lesser impact than in the polls (see chart below).

How much the current jittery capital markets would fall is anybody's guess, but I suspect it would be rather more than the 10-15% they fell in January/February on the US and China growth concerns. We discussed then the negative feedback loop this can introduce to the underlying economy and indeed some of the slowing economic growth dynamic at the moment can be traced back to this market slump.

It was good to see that not all is slowing in the UK economy at the moment - this week's export numbers showed a notable pick up for the pharma industry and other exporting sectors. The recent weakness of the £-Sterling exchange rate has clearly helped the UK exporters price competitiveness.

As you will have noticed, this week's edition is shorter than usual because we have been incredibly busy implementing various changes to portfolios across all Wrap platforms. After further research and much discussion, we have also made an adjustment to the extent of changes I briefly discussed here last week. Namely, we have in the end decided to follow the Ibbotson/Morningstar asset allocation change to reduce the commercial property exposure in the lower risk portfolio before the referendum date. The detailed background to this risk mitigating move can be found in the second article.