After several months of aggressive selling of stocks in late 2015 and early 2016, the culprit for the indiscriminate liquidation and concurrent market swoon was revealed when it emerged that the seller was not only China (which was forced to sell USD-denominated reserves to offset a surge in capital outflows following the Yuan devaluation), but also Sovereign Wealth Funds belonging to oil-exporting countries, who were dumping billions in risk assets to offset the collapse of the price of oil, which in turn exacerbated current account and budget deficits.
Among the prominent sellers was Norway and Saudi Arabia, arguably the biggest casualties of the death of the Petrodollar to date, as well as Abu Dhabi, Kuwait and most other SWFs, listed on the tabel below.
As JPM calculated back in January, the SWF equity selling was inversely proportional to the price of oil: according to the bank, SWF's would liquidate some $75 billion in equities in 2017 assuming oil at $31 per barrel. Needless to say, the lower oil goes, the more selling there would be.
"This prospective $75bn of equity selling by SWFs in 2016 is not huge but becomes significant after taking into account the potential swing in equity fund flows," JPM continued, in an attempt to discuss the impact this will have on markets. "Last year retail investors bought $375bn of equity funds globally. This year we expect an amount between 0 and $200bn. Subtracting $75bn of selling from SWFs would leave the overall equity flow from Retail+SWF investors barely positive for 2016."
Then starting in February, oil - which had just tumbled to the low-$20s, its lowest price in over a decade - underwent a miraculous surge catalyzed by erroneous, if constantly reiterated, narrative of an imminent OPEC supply cut, a short squeeze, an algo stop hunt, an unprecedented Chinese importing spree to replenish its now almost full Strategic Petroleum Reserve, and even speculation of central bank intervention to prop up the "black gold." In fact, just a few months after February, oil had doubled, reaching $50 even as we and many others warned, that there simply is not enough demand and far too much supply to sustain such a price.
No matter the cause, the biggest benefit of this oil surge is that the same SWFs which were actively selling stocks in early late 2015 and early 2016 put their liquidation on hold as oil rose above $40. And in this illiquid, low volume market, the absence of a determined seller is all that it took to push the S&P to all time highs, and as of Friday's close, just shy of 2,200, a level which even sellside brokers such as Goldman believe is effectively in bubble territory and in the 99% percentile of all overvalued metrics.
However, just a few weeks later we are now back in a crude bear market, with oil briefly dipping under $40, on the back of concerns about a gasoline glut and fears that the resurgent dollar will further pressure oil. Worse, with oil returns back to the $40 range and threatens to accelerate the move to the downside, it also brings back with it the specter of SWF liquidations, because as JPM's Nikolaos Panigirtzoglou points out in his latest weekly note, that's where the wealth fund selling returns.
Here is why as oil approaches $40, the price of crude suddenly matters a lot to equity bulls:
We had noted in F&L April 22nd what the impact would be of a $45 average Brent oil price on SWF behavior. At the time, we noted that the stability in oil prices meant that the pressure on SWFs to abruptly sell assets would diminish over time. In addition, we argued that SWF selling should focus more on fixed-income securities during the last three quarters of the year, given that SWFs mostly liquidated equity and HF mandates during last year and the first quarter of this year. However, given recent declines in oil prices, we revisit the analysis assuming an average oil price of $40 for 2016 vs $45 before. The YTD average has already fallen to $42.
In our previous analysis based on a $45 average oil price for 2016, we projected the current account balance for oil-producing countries to worsen from around -$70bn in 2015 to -$140bn in 2016. This estimate is based on the same sensitivity of the current account balance to the change in oil prices as last year, i.e. between 2014 and 2015. However, the depletion of official assets could be higher than the current account deficit if these countries also experience capital outflows as it happened last year. If we assume $80bn of capital outflow for 2016, the same level as last year, we project a depletion of $150bn in FX reserves and a depletion of $50bn in SWF assets.
If we assume an average oil price of $40 for 2016 instead, using a similar sensitivity analysis and assumptions as described above, we project the current account balance for oil-producing countries to worsen from around -$70bn in 2015 to -$183bn in 2016. This would imply depletion of $170bn in FX reserves and a depletion of $75bn in SWF assets.
The differences in the SWF selling using the two different average oil price assumptions can be seen in Figure 9.
A $40 average oil price, and assuming that these reserve managers and SWFs sell in accordance to their average allocation, would imply selling of $118bn of government bonds and $45bn of public equities. If we assume reserve managers and SWFs are mostly done with selling equities and that they are more likely to liquidate fixed-income mandates, this would imply selling of around $120bn-$160bn of government bonds and $10bn-$15bn of corporate bonds. However, should oil prices continue to fall further below $40 on a sustained basis, SWFs would face greater pressure to sell equity mandates, similar to the end of last year and the beginning of this year.
Indeed: the lower the price of oil drops, the faster what until recently had been a paradoxical disconnect (and even a negative correlation between oil and risk assets as we showed earlier), will recouple. And it's not just the SWF selling: recall that earlier this week, JPM's head quant Marko Kolanovic warned that should oil return back to the $30s, it would also trigger program selling of stocks.
CTA signals for oil recently turned from strongly positive to moderately negative. This has contributed to past-month divergence between S&P 500 and oil (~1.5 standard deviations) and is closely monitored by equity and high yield credit investors. It is our view that the risk of CTAs significantly increasing oil shorts over the next 1 month is low. For oil momentum to further deteriorate, oil would need to drop to ~$30 at which point the medium term momentum (strongest signal) would turn negative and trigger selling.
To summarize, if oil were to drop back under $40, not only would it precipitate even more selling of oil as momentum strategies flip, but it would catalyze a liquidation by those SWFs who thought they were done selling equities, leading to a return of the same sellers that pushed the S&P back to the low 1,900s a short 6 months ago.
So for all those curious where stocks are going next, the simple answer is: keep an eye on what oil does next.