- David Wolf
Fidelity Viewpoints: Canada’s Oil Slick
Positioning For Further U.S.-Canada Divergence
Oil prices have collapsed. As I write, the benchmark West Texas Intermediate (WTI) oil price sits at $55 per barrel – barely half of its level of six months ago (see Exhibit 1). The plunge looks predominantly due to the effects of higher-than-expected oil supply on what is always a finely balanced market. U.S. oil production has grown more quickly than anticipated, and long-time swing-producer Saudi Arabia has decided not to offset that by cutting its own production – betting instead that short-term pain will produce long-term gain by crowding out the higher-cost shale producers and thus restoring Saudi oil market dominance. As this process plays out, over a period likely to be measured in quarters or even years, the base case must be for oil prices to remain at levels well below those we’ve gotten used to over the past several years.
EXHIBIT 1: Drilled Benchmark crude oil prices, USD/bbl
The collapse in oil prices has its fingerprints all over performance across asset markets in recent months, generally reflecting the sensible principle that lower oil prices are good for those who consume oil and bad for those who produce it. So airline stocks have soared while energy companies have sunk; the U.S. dollar has risen further while the Russian ruble has plunged; the energy-heavy U.S. high-yield bond market has sold off despite the rally in U.S. government bonds. Closest to home, the Canadian equity market – whose weighting in energy stocks is more than double that of emerging markets, EAFE or the U.S. – has underperformed dramatically (see Exhibit 2).
EXHIBIT 2: Canada’s underperformance Cumulative % change in MSCI total return equity indexes since July 1, 2014, CAD terms
Under these circumstances, our job as asset allocators is to determine where asset classes have either under- or overreacted to the plunge in oil prices and its consequences. In such dislocations lie opportunities. From the current vantage point, two particular opportunities stand out.
One, global equities have not reacted positively enough to the plunge in oil prices, in my view. The MCSI All Country World Index (ACWI) of global equities is essentially flat over the past six months. But cheaper energy is good for the global economy and particularly good for the U.S., Europe and Japan, all big net oil importers that make up more than 80% of the ACWI. Equity investors may have been looking at movements in global bond markets and fretting that the additional decline in yields may indicate a further weakening in the global growth outlook. But, as noted above, the drop in oil prices looks to be far more about higher supply than lower demand, making it ultimately good for growth – a positive for what already appeared to be a global economy in a solid if unspectacular mid-cycle expansion. The decline in government bond yields in recent months is better interpreted as a reaction to the disinflationary consequences of lower oil prices, which, among other things, should further extend the U.S. Federal Reserve’s willingness to maintain its exceptionally stimulative monetary policy. We have long preferred stocks to bonds, with the former at generationally cheap levels relative to the latter; the valuation advantage for equities has now improved somewhat further.
Two, the Canadian dollar and Canadian assets more generally have not reacted negatively enough to the plunge in oil prices, in my view. Markets seem to have been pretty efficient in discounting the direct effects of cheaper energy on Canadian asset prices, but are almost certainly underestimating the second- and third-order consequences, in my judgment. The popular narrative has been that these lower oil prices are a mixed blessing for Canada: bad for oil producers but good for the vast majority of Canadian consumers; bad for Alberta but good for larger provinces like Ontario and Quebec; bad for the energy sector but good for the manufacturing sector in Canada, particularly given the associated boost to U.S. demand and the past depreciation of the Canadian dollar. These relative views are correct, but I would expect that the absolute effect on the overall Canadian economy will be more challenging than is currently perceived.
Higher commodity prices, oil prices in particular, have set in motion a number of virtuous circles in Canada over the past decade or so. Higher commodity prices have driven up national income in Canada, including the incomes of companies, consumers and governments across the country that have nothing to do with the energy patch directly. Higher commodity prices have also boosted the Canadian dollar, which has limited the inflationary consequences of the boom and so allowed the Bank of Canada to keep interest rates very low. The result has been mutually reinforcing increases in Canadian confidence, spending, borrowing and asset prices, resulting most notoriously in record levels of Canadian household debt taken on against overvalued residential property across much of the country (see Exhibit 3). These linkages are all difficult to quantify, which is why they’re underappreciated. But we know they’ve all been working in the same direction – up.
EXHIBIT 3: More linked than you might think Commodity prices and housing investment in Canada
And now they’ll all work in the same direction – down. Lower commodity prices threatened to turn these virtuous circles vicious in Canada through 2008–09, but central banks came to the rescue with aggressive stimulus. With rates on the floor across much of the world, that can’t be repeated. The Bank of Canada does have a bit of room left to stimulate, although it will likely be hesitant to use it in the near term, partly to avoid the risk of exacerbating the household imbalances that have grown much larger since the crisis. But with lower commodity prices representing an unambiguously deflationary shock for Canada, the probability that the Bank does eventually have to put interest rates back at zero has increased substantially – a risk that markets are clearly not discounting at this point. While such an outcome would further support the recent strength of the Canadian bond market in local currency terms, it would deal a further blow to the Canadian dollar, and thus the relative performance of Canadian assets more generally.
My inaugural commentary for Fidelity Canada last spring was entitled “Leaving home,” which argued that better investment performance could be expected from moving out of Canadian assets into U.S. equities in particular. Our fundholders benefited from that positioning in 2014. We expect them to continue to do so in 2015.
Oil price plunge reflects positive supply shock
Good for equities…
…but not so much for Canada
David Wolf, is Portfolio Manager, Co-Manager of Fidelity Canadian Asset Allocation Fund, Fidelity Monthly Income Fund, Fidelity Dividend Fund, Fidelity Income Allocation Fund and Fidelity Conservative Income Private Pool
Originally published in ‘Leadership Series Fidelity Viewpoints, First Quarter 2015’
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