What happened?
This Article was written by the Investment analysis team with Alliance Bernstein
Following the breakdown of talks between Russia and Saudi Arabia over the weekend and Saudi Arabia’s aggressive strategy of significant oil production increases, crude oil experienced it’s largest one-day decline since 1991 on Monday; down c.24% to close at around $35 a barrel, after dropping as low as $31 intra-day (using Brent crude prices)
This precipitous fall marks close to a 50% drop from the YTD peak, making this one of the largest and fastest decline from peak in oil prices in percentage terms since records began (compared to historical median price declines of around 34% in previous oil price crashes)
At the time of writing, oil prices have bounced back around 10% and are currently trading around $37 a barrel; though this is still over $10 below where prices were trading at the end of last week
How has EM been impacted?
- 40% of the EM hard currency sovereign index are oil exporters, an increase of 25% since the end of 2015 largely driven by the addition of the GCC region into the index
- It’s worth remembering that emerging markets comprise a large and diverse range of countries, and therefore contains many oil importing nations who benefit from lower oil prices from a current account perspective
- However, for many countries this benefit has been offset by the fact that this negative oil price move is in the context of broader concerns over the coronavirus and a significant risk-off tone across global markets, leading to negative returns overall
- Until Monday’s price action, the EM hard currency index was up 2% in the first few trading days of March, recovering the 2% fall experienced towards the end of February as coronavirus fears gripped the market
- However, Monday’s price action in EM turned sharply negative, as the index returned -3.79% on the day, as spreads widened almost 70bps on the day to 470bps; the widest since early 2016. This has contributed to MTD index returns of -2.70%
- Regionally, the negative price action was driven by Sub-Saharan Africa, Latin America and the Middle East, given the heightened oil sensitivity of those regions, with high-yielding oil exporting names suffering most
- Asia and Central and Eastern Europe have been the relative outperformers given countries in these regions tend to be net oil importers, though we also saw negative returns here given the broader risk-off sentiment
Sub-Saharan Africa:
- Sub-Saharan Africa was the worst-performing region, with the names hit hardest including the more vulnerable oil producing nations such as Angola, Gabon and Nigeria
- Our external and fiscal funding gap analyses showed these names to have the highest vulnerability to an oil price sell-off such as this
- We believe that of the three, Gabon is the best insulated, while Nigeria and Angola would have large financing needs relative to reserves, with oil prices sustained at these levels
- Nigeria also has a local market with heavy foreign investor involvement, and could therefore see pressure on the currency also
- It’s worth noting that Angola is on an IMF programme and has been engaged in a series of structural reforms which could potentially see further assistance granted
Latin America:
- Latin American names also suffered, with Ecuador the standout underperformer; down almost 23% at an index level on the day
- As a rule of thumb, for every dollar decline in the price of oil, Ecuadorian fiscal revenues decline by $70m, given the country’s large reliance on oil exports
- This hit Ecuador particularly hard given the country’s prior challenges in addressing an IMF-mandated fiscal consolidation. However, we believe that price action of that magnitude is overdone, and are looking to tactically increase exposure from flat to the benchmark on the view that we are now being adequately compensated for the risk
- Elsewhere in Latin America, Colombia and Mexico were underperformers, while Pemex (the Mexican state-owned oil company) bore the brunt of the sell-off given Pemex’s already challenging financial position
GCC:
- Finally, the GCC region was also hit, though to a lesser extent than the more vulnerable oil producing nations in Sub-Saharan Africa and Latin America
- GCC names tend to be of higher credit quality, with generally stronger sovereign balance sheets and higher level of FX reserves; meaning they are far-better prepared to weather a prolonged period of oil prices than comparable Sub-Saharan African or Latin American names
- However, there are names which are more vulnerable in this space, with Oman and Bahrain standing out as the weakest in terms of the scale of their FX reserves and negative fiscal balances
- However, to differentiate between the two names, Bahrain currently benefits from financial support from Saudi Arabia, Kuwait and the UAE, while Oman’s standalone fundamentals leave the country more exposure; in the absence of external financial support
Local Currency Sovereign:
- It was a similar story on the local currency side, where the index was down -2.46% on the day
- This was led by negative FX returns of -1.93%, primarily due to the underperformance of petrocurrencies such as the Colombian peso, Mexican peso and Russian rouble
- Other ‘high beta’ or risk-sensitive currencies such as the Indonesian rupiah, South African rand and Brazilian real also delivered negative returns
- Local rates held up better but were still negative, returning -0.54% overall
- Similar to the hard currency universe, local markets in Europe and Asia were the relative outperformers given countries in these regions tend to be net energy importers
How has market liquidity been?
- As is typical in times of heightened market volatility, liquidity has been lower on both sides than it would have been in normal market conditions
- In the hard currency space, liquidity has deteriorated most in HY names relative to IG, and within HY it has been oil-exporting names which have seen liquidity most challenged
- Sub-Saharan Africa has seen the most challenged liquidity conditions, particularly Angola and Nigeria
- Elsewhere, trading in Ecuador and Ukraine has also taken a hit, amidst a general flight to quality within the asset class into IG names where liquidity has been better (including GCC names despite the move lower in oil prices)
- Lebanon is another country where liquidity has meaningfully reduced, though for reasons unrelated to the coronavirus and oil price moves
- In local currency, liquidity has held up relatively well over the last several weeks, though bid/ask spreads have been wider
- The important distinction to make in this space is that the lowest yielders have generally followed the moves in developed market rates, while the highest yielders have started to track moves in macro/FX markets
- Frontier local currency markets have seen meaningful decreases in liquidity, with correspondingly higher bid-ask spreads in currencies such as the Nigerian naira
- Liquidity has been better in Asia, with local rates still offering good liquidity
How are we analyzing the situation?
- We think it’s unlikely that Saudi Arabia’s aggressive oil pricing strategy is likely to force Russia into significant production cuts any time soon, considering Russia’s strong fiscal position. However, there are many political factors in play which could force either party back to negotiations
- We consistently stress test our portfolios for events such as these, whilst also conducting external and fiscal funding gap analyses on the broader market to assess which names are most vulnerable, and where potential opportunities lie subject to market pricing
- We performed a comprehensive stress test towards the end of 2019, which we have recently renewed given the oil price reaching as low as $30 a barrel for Brent crude. We have used this price level to stress test portfolios despite our view prices will not remain at these depressed levels going forward, particularly given current forward curves imply oil prices should revert back to $40 after around 6 months
- It’s important to remember that oil markets are currently suffering from a simultaneous supply and demand shock; we do not think either will persist over the longer term and are therefore assuming in our analyses that it is unlikely that oil prices will remain at current levels over the longer-term
- From the demand side, the coronavirus will eventually dissipate, and demand will then begin to pick up from significantly depressed levels
- On the supply side, oil prices in the $30s do not make it economical for high oil cost producing countries to continue. Prices at these levels mean capex dries up, leading to drops in production levels which cap additional negative oil price moves
How have we been positioned?
- The investment implications of our most recent analyses were to rotate some of our pre-existing oil exposure into names where we believe the recent sell-off has been disproportionately large
- An example here is a switch from our positioning in Oman into Ecuador, given extreme negative price moves in the country’s assets
- Given our relative preference for Gabon amongst Sub-Saharan African names, we remain comfortable with our overweight position there, but are looking to reduce our exposure to Nigeria which we believe is more vulnerable
- In terms of our positioning elsewhere, we have been tactical with the use of CDX EM, having used opportunities of price dislocations to increase our exposure which we then unwound quickly in periods when markets rose
- We have also been adding exposure to Pemex into significant market weakness
- Our exposure to pure US duration helped portfolios in February given the strong rally in US Treasuries, and following that we have continued to rotate this pure US duration exposure into IG-rated EM hard currency sovereign names such as the Philippines and Russia
- We are also looking to add exposure to Ukraine which has come under pressure in recent days
- The negative price action in Ukraine can be explained partly due to it being a consensus overweight and partly due to recent political changes which caused investors to question the country’s commitment to reforms
- We have taken this opportunity to add some exposure here, given cleaner positioning and our less negative assessment of their commitment to reforms following the cabinet reshuffle
