A casual glance at returns year to date confirms markets have been on a bit of a tear. Prevailing macro conditions – reasonably strong, synchronised economic growth and easy monetary policy – suggest good performance is warranted.
However, investors have known about this for months now and there is a limit to how many times you can discount the same good news into prices. We may now be close to that point. Valuations in many asset classes are stretched and sentiment is extended.
We have come a long way since early 2016, when investors saw bad news as good news because it led to more central bank support. Now we find ourselves reaching for the opposite maxim: it’s so good, it’s bad.
Certainly, it is time to be alert to the risk of becoming complacent. Taking some chips off the table strikes us as a sensible step right now. It is a good time to look for areas that have failed to participate in the rally.
Not much fits the bill at an asset class level but commodities do appear to be an exception to the rule. Bloomberg’s broad commodity index is roughly flat over the year, while energy, its biggest component, is down by around 10 to 15 per cent.
At a macro level, this makes some sense. At the beginning of the year, the oil market was giddy with expectations of reflationary or even inflationary policies by the new Trump administration. Tax cuts, infrastructure spending and protectionism were judged to be good for commodities and the US dollar. However, 2017’s story has been the US administration’s failure to implement its own pro-growth agenda. Inevitably, meaningful price adjustments have occurred, with oil caught in the cross fire.
Looking at underlying energy market fundamentals, though, it is not nearly so obvious that oil should have disappointed. Oil demand has been good. Compliance with Opec production cuts has been good. Forecasts for global growth have been very good. Lower prices stimulated demand in developed markets and high growth kept emerging market demand going.
The net result of all this has been regular draws from oil stockpiles. That usually supports spot oil but it singularly failed to do so in the first half of the year. Instead, good news was routinely ignored and bad news priced in.
Oil equities have been worse than oil itself. Over-enthusiasm at the start of the year proved a headwind and the first half saw a dramatic unwind of investor positioning. The energy sector was 20 per cent behind the S&P 500 by the middle of the year – its worst start to the year in many decades.
Yet in the background, oil companies have undergone a quiet revolution, to the point where some can generate more cash with oil at $55 a barrel than they did four years earlier when it was above $100. That gives you some idea of the extent to which companies have changed their operations.
So why has this not helped? Momentum has been powerful this year and oil stocks have been perceived to have none. Positioning and sentiment have been somewhat mixed in the oil market but uniformly negative for oil equities.
Meanwhile, investors have been lured into four large caps – Facebook, Amazon, Netflix and Alphabet (was Google) – and the cash to buy them has had to come from somewhere. Oil was almost certainly a source of that.
That said, fortunes have recently taken a turn for the better. Today’s circumstances look good for a continued re-bound in oil, and especially in oil equity. The oil market continues to tighten, having moved into backwardation recently, where immediate spot prices are lower than future ones. This better technical backdrop has been supported by the high compliance with Opec production cuts.
While shale has come back, its costs have surprised to upside and there is only so much capacity producers can turn on, even with shorter lead times than conventional oil.
The market is now thinking about whether we will continue to see production restraint from Opec, with the current agreement due to expire in March. There has been a few glimmers of hope in recent weeks with some high-level engagement between the Russians and Saudis. This greater willingness to work together could be a pre-cursor to an extension of the existing production quotas.
But there are also geopolitical wildcards, such as if the US unpicks the nuclear deal with Iran, potentially hampering Iran’s oil industry by cutting off foreign expertise and investment.
While many markets appear fully valued, oil offers investors a rare chance to take risk at a reasonable price. Share prices appear to have bottomed over the summer and, while we have seen a reasonable bounce since then, oil equities remain under-owned. There is more to come from the black gold.
Bill McQuaker is portfolio manager of Fidelity’s Multi Asset Open Range