The recently high correlation between equity markets and the oil price is unlikely to continue, according to AXA IM’s Laurent Clavel, who says global stocks will no longer need sentiment towards oil to improve to rally from here. 
Equity investors have had a largely torrid time of late as macroeconomic headwinds have shaken global risk appetite.
China’s slowing growth and currency devaluation have been the primary cause for concern, yet the substantial falls in the oil price have added to those woes. In fact, the two are largely related, given China is the world’s second largest economy and therefore slowing growth will hurt demand.
At the same time, there has been a serious case of over-supply in the market with OPEC unwilling to cut production and Iran re-entering the frame.
According to FE Analytics, the S&P GSCI Brent Crude Spot index has fallen a substantial 38.48 per cent over the past 12 months and the oil price currently stands at a little over $30 a barrel. While not as painful, the MSCI AC World index is down some 6 per cent over that time.
This correlation has only increased so far in 2016, with both global equities and the oil price posting significant losses. Also, global equities have only seen periods of mean reversion when the oil price has rebounded.
Performance of indices in 2016
Source: FE Analytics
Clavel, senior international economist at AXA IM, says this dynamic will start to change soon, though.
“We believe the positive correlation between oil prices and equities is not robust. Yes, oil is probably used as a financial risky asset but it also remains a commodity, with a (currently overflowed) physical market,” Clavel said.
“The positive correlation however proved stubborn in the short run, with an upward correction in both oil prices (the confidence in net short positioning was possibly shaken by recent news headlines suggesting that Russia and Saudi Arabia could cooperate in order to reduce oil production) and global equities (probably driven by the unexpected easing from the Bank of Japan).”
There are two schools of thought on the impact the recent oil price falls will have on equity markets.
The one most widely touted is that the falls are a positive, particularly for the developed world, as corporates need to spend less on input costs while consumers have effectively been handed a huge tax break as they need to spend less at the pump.
“What does the US consumer do a lot? They drive and eat, and both food and energy prices have fallen a lot, so that is helpful for disposable income trends in the US,” FE Alpha Manager James Thomson recently told FE Trustnet.
“We haven’t seen a wave of spending yet but again, that may be good news to come down the road.”
On the other hand, others warn that the falls in the oil price is a signal of slowing global demand and a precursor to slowing global growth. As a result, they argue this will act as a negative towards equity market sentiment.
Clavel sits in the former camp.
“In the medium run, we believe several structural factors are playing on the oil market (Saudi Arabia’s change of strategy, the correction in non-commercial positioning) and therefore expect low oil prices to remain with us for several months, independently of evolutions on the global stock market,” he said.
“We however fully recognise our inability to foresee to which (medium-term) equilibrium price this free fall will end. In the long run, we expect oil prices to go back to a higher, more sustainable level (on the oil supply side): this extremely low level (unprecedented since 2003) should lead to a further tightening in tech oil financial conditions, and ultimately to a decrease in non-conventional oil production.”
Performance of indices over 15yrs
Source: FE Analytics
While that is Clavel’s base case scenario, he says there are two symmetric risks regarding the future of oil prices and equity markets.
The first is negative, according to Clavel, and relates to a drop in the oil price potentially leading to a further tightening in monetary conditions.
“[This] could spill over to the entire corporate sector, especially in the US. This in turn could provoke a sharp economic slowdown. Gold (which is currently not suffering from the drop in commodity prices and may still rebound if global demand surprises on the upside) could offer a hedge,” Clavel explained.
Certainly, gold bears have so far been proved wrong in 2016 as despite a lack of inflation and falls in other commodity prices, the price of the yellow metal has spiked by some 11 per cent since early December.
That being said, many – such as Psigma’s Tom Becket – say this rally has more to do with investors losing confidence in central bankers more than anything else.
“There is also the chance that investors’ faith in central bankers diminishes, which might best be seen through gold's recent rally,” Becket said yesterday.
“I have long maintained that these events make me much more worried about inflation later this decade than deflation, despite others obsessing more about lower prices. The worry is that ultimately central bankers are too successful in their inflationary aims.”
The other symmetric risk may be a positive, though, as Lavel says it would help bombed-out areas such as regions within the emerging market world.
Performance of indices over 3yrs
Source: FE Analytics
“The second symmetric risk is an upward, potentially sudden, correction in oil prices. This would not necessarily come from any change in the oil physical market, but simply correspond to the usual end of a (here negative) asset price bubble, offering a respite for the major commodity-related asset classes and currencies of developed oil producers,” he said.
