Time to strap in for the downsides of cheap oil, higher interest rates

From higher interest rates to collapsing oil prices, and everything in between, financial analysts say the markets are laced with risks, many of which are being ignored by investors and financial advisers.
On the sinking price of crude oil, which has dropped 31%, to about $56 a barrel, in less than two months, the impact of the downside is starting to come into focus.
While most U.S. consumers are blissfully enjoying gasoline prices at levels not seen in years, the pain at the production end of the oil industry is sending ripples across the globe, threatening the health of the booming U.S. oil industry as well as oil-dependent economies such as in Venezuela and Russia.
“I think the big story with oil is 80% positive and 20% negative, but the negative is really bad,” said Douglas Cote, chief investment strategist at Voya Financial Inc.
“For Americans and any country that is a net importer of oil, low oil prices helps consumers, but I’m concerned that everyone is only looking at the good side,” Mr. Cote said. “Russia is on the brink of collapse because of the falling oil prices, and that means they could default on their debt like they did in 1998.”
Investors and financial advisers also should be thinking about the impact on U.S. oil corporations with multibillion-dollar projects “that have been financed by high-yield bonds owned by U.S. investors,” he added.
The U.S. oil industry, especially smaller companies, has become heavily leveraged by the oil boom. That leverage translates to high-yield bonds held by investors. If oil prices stay low or go lower, those bond yields are at risk because the companies are going to have a harder time making a profit to finish their projects
Peter Schiff, chief executive of Euro Pacific Capital, concurs that the fallout from cheap oil is largely being ignored by an investment community fixated on the roaring equity markets, which are up 14% this year after a 32% gain last year.
According to Mr. Schiff, the same Federal Reserve monetary policy that has been driving stocks higher will have to jump back in and rescue the economy unless oil prices start rebounding.
“Even though lower oil prices are good in the long run, in the short run, the loss of jobs in the U.S. oil business and loss of money invested in drilling … will be enough to push the economy back into a recession,” he said. “The oil industry has been a big component of the U.S. recovery, and if that unwinds … there is nothing to take its place.”
With that scenario as context, Mr. Schiff said, that instead of raising interest rates next year, as the Fed has been hinting it will do, it will likely end up introducing another round of quantitative easing to keep the economy from imploding.
But Joseph Witthohn, vice president and portfolio manager at Emerald Asset Management Inc., doesn’t necessarily agree. Instead, he is watching — and listening — to the Fed’s rate language.
“While the soothing words of the Fed were celebrated over the past week, a wild card is what will happen when the tone changes,” Mr. Witthohn said. “If rates rise and borrowing — including mortgages — becomes more expensive, will equities look as attractive as they do to some today?”
His biggest concern is not the impact of higher rates on the economy or individual companies, but the uncertainty “of how consumers will react, or overreact, once the Fed announces the economy is, in fact, strong enough to stand on its own without continued support,” Mr. Witthohn said.
The market is not immune to a reaction similar to the so-called taper tantrum in May 2013 following the Fed’s announcement that it planned to start winding down its five-year quantitative easing program, when a knee-jerk move by investors out of bonds temporarily caused a small spike in bond yields.
Some equity sectors that have benefited from lower bond yields could be at risk if the Fed raises rates next year, in what would be its first hike since 2006.
“Higher rates won’t just be a negative for fixed-income investments but will hurt high-yielding equity sectors like utilities and consumer staples,” said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ. “Dividend stocks tend to be bond proxies, and when rates rise, investors tend to go back to bonds for the yields.”
Market strategists also point out that the U.S. equity markets have now gone three years without a correction or 10% or more. Historically, stocks have corrected on average every 18 months.
Meanwhile, Mr. Schiff doesn’t see the Fed with any real plans to raise rates anytime soon.
“If the economy is so strong, why haven’t they already raised rates, and why do they need to wait another five months to do it?” he asked.
The way Mr. Schiff sees it, the Fed is in a classic pickle.
If oil prices fall further or stay low, a large portion of the economy will suffer, thus weakening the indicators the central bank is using to justify raising rates next year.
But if oil prices revive, the economy will have to deal with a dampening of consumer spending and confidence, which have been strengthened by cheaper oil and are supposedly putting the economy on solid enough footings to support a rate hike.
“I think the Fed has succeeded in creating the biggest bubble yet,” Mr. Schiff said. “If this has been a recovery, where are the rate hikes? One of the reasons you raise rates during a recovery is so that you can cut them during a recession.”

Related Topics: Federal Reserve