Global equity markets could see a huge correction in the event oil prices fail to carry on their recovery and tumble to $10 per barrel, according to Raghu Suryanarayanan, executive director of risk and regulation research at MSCI.
The oil price has staged a partial recovery since it began to plummet in June 2014 but is still down more than 65 per cent from its last high.
Performance of index since June 2014
Source: FE Analytics
The trend downward in the oil price and ongoing wild fluctuations have been a huge driver of market sentiment, economies and asset prices around the globe over this near two year period, says Suryanarayanan.
“While low oil prices driven by oversupply generally benefit consumers and equity markets, prices that stay too low for too long can stress oil-producing nations, push energy companies toward default, and strain the global financial system,” he said.
There has been some tentative signs of recovery in the oil price in recent weeks but most traders and investors are quick to point out that nobody apart from a few senior Saudi oil executives have any notion of whether it has reached a floor.
In this article, we take a look at three possible scenarios for the price of oil with Suryanarayanan revealing how these might affect a typical multi-asset class portfolio.
A year of oil at $10 a barrel
Motivated by maintaining market share, this scenario assumes that major oil producers do whatever it take to not lose any ground and push prices down further. This could even mean driving the price of crude down to $10 per barrel for a year or so.
By doing this, Suryanarayanan says, the likes of Saudi Arabia will destroy the profitability of drilling for all but a few producers worldwide and unleash havoc for all but government bonds.
“A wave of defaults by energy companies and credit losses to banks that result causes the U.S. financial sector to lose as much as half its value and increases systemic risk worldwide. The scenario also assumes that growth declines by 3.1 per cent in developed economies and by 4.9 per cent in emerging markets over the period,” Suryanarayanan said.
“Consumer prices globally would fall by 0.4 per cent. The decline in energy prices may be accompanied by further declines in interest rates.”
“The plunge could cause global equities to fall nearly 23 per cent. Investors may seek assurance in developed market government bonds, which could gain 3.4 per cent. By contrast, emerging market government bonds could fall nearly 30 per cent. An index of corporate bonds could fall 19.4 per cent globally and 20.4 per cent in emerging markets.”
The chart below shows how a multi-asset portfolio invested globally could lose 17.3 per cent in this scenario, according to Suryanarayanan.
Source: MSCI
A year of oil at $35 a barrel with an uptick in systemic risk
In this scenario, the price of a barrel of oil hangs at $35 for a year. This benefit to consumers in the form of lower prices which partly offsets an increase in risk of the danger of defaults among energy companies.
Suryanarayanan said: “The scenario further assumes that growth slows by 0.25 per cent in developed markets and 1 per cent in emerging markets, while consumer prices fall 0.2 per cent worldwide. In this scenario, a multi-asset class portfolio invested worldwide could lose 5.1 per cent.”
“Global stocks could lose 6 per cent. An index of developed market government bonds could gain 0.7 per cent, while a similar index in emerging markets could lose 15.8 per cent. Returns on corporate bonds may shrink 4.6 per cent globally and 7.4 per cent in emerging markets.”
Source: MSCI
A year of oil at $35 a barrel without an uptick in systemic risk
Lastly, in Suryanarayanan third scenario he assumes there is supply-driven decline in oil prices and the energy sector and oil exporters suffer but that the global economy enjoy the effects.
“The scenario further assumes that growth ticks up by 1 per cent in developed and emerging markets, and that consumer prices fall about 0.2 per cent over the period. With investors less worried about a step-up in systemic risk, the scenario could produce a gain of 3.5 per cent in a multi-asset class portfolio invested globally,”
“Stocks could rise 5.8 per cent worldwide. An index of developed market government bond could lose 0.8 per cent, while an index of emerging market government bonds could gain 1 per cent. A corporate bond index may rise 1.3 per cent globally and about 1 per cent in emerging markets.”
Source: MSCI
