The Financial Times published an article entitled “Oil price fall starts to weigh on banks” as the oil price hit a four-year low.  The article highlights how the drop in the price of crude, which has dropped 30% since June, is having repercussions beyond the energy sector – e.g. hitting currencies, national budgets as well as energy company shares.  Below is chart with the direct lending exposure to the energy sector.  Scotiabank’s lending exposure to the energy sector is highest, while Bank of Montreal saw the biggest lending increase.  The Big 6 banks in aggregate have direct lending exposure to the energy complex totaling $46.9B, which represents 2.3% of their total loan portfolio.

Canadian Banks Exposed to Energy Lending

The other potential problem area following this big drop in oil price and dim short term prospects is the junk bond market.  Massive investment by oil drillers and exploration companies in U.S. energy and shale gas projects in recent years has been partly financed via cheap borrowing conditions across capital markets.  Energy debt now accounts for 16 per cent of the US $1.3 trillion junk bond market, up from a share of 4 per cent a decade ago.  Nearly a third of issuance trading so poorly it currently qualifies as being classed as distressed, indicating a high likelihood of being restructured.

Canadian stocks have moved higher since the mid-October lows, but have lagged the move in other major markets due to the collapse in Energy and some other commodity-based stocks.  The non-resource stocks have been the beneficiary of this latest recovery.  Consumer stocks have been among the best performers, pushing to record highs in November.  Canadian Industrial stocks have also done well amid lower input and transportation costs and a lower Canadian dollar, which benefits exports.  Valuations have also moved higher as these groups benefit from the move out of resource stocks.  That leaves Canada as the odd market out. Note that energy makes up 22% of the TSX even after the recent slide, precisely the weight of consumer discretionary and staples in the S&P 500, the sectors that arguably stand to benefit most.  Inversely, energy is just over 8% of the S&P 500, or roughly in-line with the share of consumer stocks in the TSX.  This is not a new revelation by any means, but just serves to highlight that, in this oil price environment, the deck is stacked heavily in favour of U.S. equities and against those in Canada.

In terms of the impact of lower oil prices on the global economy, there are clear winners and losers but the net impact has to be viewed as positive.  Geographically, the U.S. benefits from the steep drop in oil prices (even though the domestic shale oil boom will slow).  North Dakota / Montana / Wyoming and Texas / Oklahoma are regional losers due to their strong production profiles.  Other losers are higher-cost oil producers whose economies are dependent on oil exports.  Venezuela, Russia and Iran top that list.  The Russian Economic Development Ministry just revised its GDP forecast for 2015 from growth of 1.2 percent to a drop of 0.8 percent.  Disposable income is expected to decline by 2.8 percent against the previously expected 0.4 percent growth and the overall economy will sink into a recession.

Big oil importers such as China, Japan and Europe are beneficiaries but the biggest winners are the emerging markets—with India being singled out as a major oil importer. With economic growth on a clear recovery path in India and the new government pushing through powerful reforms, the Indian stock market looks like one of the best values in the overall global market over the next year.  The move in energy prices will lead to a massive transfer of wealth in many sectors and geographies.  Markets are only just starting to sort out the implications and all we really know is that this adjustment will lead to a higher level of volatility in financial markets.

For stock market investors in general though, we continue to advocate caution.  We see more ‘cheerleading’ for the stock market than balanced analysis.  Easy central bank policies seem to be the only salvation for weak economic numbers, extended valuations, slowing profit growth and excessive investor optimism.  Record low interest rates and bond market purchases by central banks appear to have only inflated the value of financial assets.  Five years of zero interest rates in the U.S. and the economy is still only growing at about 2.5%, and this is one of the best numbers of all major economies.  Bullish investors are ‘whistling past the graveyard’ in our view.  We have seen a tremendous gain in stocks (outside of the resource sector) in the past three years and valuations look as extended as we have seen them at any time since the last market peak in late 2007.  While momentum could still carry stocks higher through year-end, we don’t find the risk/reward trade-off at all attractive right now and continue to sell into strength and raise cash.  Resource stocks will probably find a bottom first as U.S. growth slows down a bit and the U.S. pulls back.  We expect that the next downturn in stocks will not be lead by the resource sector, but the more over-valued defensive market sectors.

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