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– January 21, 2015

The share of debt that is over 90 days past due has been falling for mortgages, home-equity loans, auto loans and credit cards, while it has been leveling off for student loans. In addition, fewer and fewer loans are becoming delinquent each quarter. In the most recent quarter, only 1 percent of current mortgages fell behind by 30 to 60 days.

Sustaining the trend towards fewer delinquencies may create positive ripple effects in the economy. As fewer borrowers get behind on payments and credit quality improves, banks may reserve less capital to cover write-offs or even release funds already set aside, thereby boosting income. This can lead to healthier bank balance sheets and eventually looser lending standards.

Fixed Income
Emerging markets and high-yield bonds are two areas of the fixed-income market that may be affected by the rapid decline in oil prices because of their outsized exposure tool. Bond markets will reflect the risk and opportunity of falling oil prices. This is true when viewed from the perspective of both government and corporate bonds.

Clearly, countries whose economies are dependent on oil exports are at risk with the plunge in world crude oil prices. However, even among net oil exporters, risk varies. For example, in Russia, oil production accounts for about 14 percent of GDP, in Norway oil production accounts for about 9 percent of GDP, and in Mexico oil production account for about 7 percent of GDP. This is in contrast to the U.S. where oil production accounts for just less than 1 percent of GDP. Yet, to understand the nature of risk associated with oil-dependent producers and how this translates for investors in bond funds, requires understanding the relative size of each nation’s debt in the fund’s portfolio. That is, while oil holdings pose a risk, the nature of the risk is influenced by the concentration of those holdings.

We can illustrate the point by comparing the SPDR Barclays Emerging Markets Local Bond fund (EBND) to the broader and more diversified SPDR Barclays International Corporate Bond fund (IBND). Between the two, the emerging market fund tends to hold more securities issued by countries that are reliant on oil exports as economic drivers. About nine percent of the EBND portfolio is comprised of debt from such countries (Russia and Mexico) while the IBND exposure is closer to two percent (Mexico and Norway). Thus, it is no surprise that since July 2014, the emerging markets fund is down 8.6 percent as compared with a 7.6 percent decline for the broader international fund.

To illustrate the point with corporate bonds we can compare sector exposures of the SPDR U.S. High Yield Corporate Bond Index (JNK) to the higher quality SPDR U.S. Intermediate Term Corporate Bond Index (ITR). The SPDR U.S. High Yield Corporate Bond Index (JNK) holds 18.1 percent of its assets in oil, gas and consumable fuels companies whereas with the SPDR Intermediate Term Corporate Bond Index (ITR) holdings in those industries is approximately half at 9.3 percent. As one would expect, the SPDR Intermediate Term Corporate Bond Fund (ITR) has outperformed the SPDR Barclays High Yield Bond fund (JNK). Since July 2014, the high yield bond fund is down 4.8 percent and the investment grade corporate bond fund is down only 0.1 percent. Should large swings in oil prices continue, expect to see those fluctuations affect emerging market and high yield bond funds more than developed market and investment grade bond funds, respectively.

The global market for crude oil has experienced a number of major changes over the past several years.
On the demand side, since 1985, during each major period of accelerating global growth, crude prices rose significantly. Conversely, during each major slowdown, prices fell. The behavior of prices was no different during the Great Recession when crude oil prices experienced a sharp decline from December 2007 to June 2009 and rebounded immediately following the recession’s end. However, global economic expansion has faltered more recently and, according to the latest forecast from the International Monetary Fund’s World Economic Outlook (IMF WEO), growth is expected to level off at a rather modest pace over the next few years.Slow growth means consumption growth is unlikely to put much upward pressure on petroleum prices (Chart 7).

On the supply side, output is largely driven by break-even prices for oil production. When producers can sell oil at a price above their break-even cost, the economics favor pumping more crude. When prices fall below that point, producers run the risk of incurring losses on any output and may be induced to shut down, at least temporarily. While it may take years to ramp up production, operations can be shuttered relatively quickly.

In the U.S., massive oil reserves have been identified over the years but much of that potential supply is in shale fields with relatively high break-even production costs. As a result, U.S. output has, until recent years, been limited to fields with lower extraction costs. However, as crude prices broke through $75 a barrel in 2010 and remained above that level, significant investment occurred to develop high-cost reserves, sending daily U.S. oil production up 56 percent in the last three years, from 5.85 million to 9.14 million barrels per day. This accounts for about 10 percent of world consumption, and has eaten into the market share of other global producers, as reflected in the rapid decline of U.S. crude imports.

Finally, the most recent development has been the decision by Saudi Arabia, the world’s largest oil exporter, to maintain output and therefore drive prices lower in order to protect its market share. Over time, lower prices will likely cause some high-cost producers to curtail output or even force some out of business, reducing global supply.           

U.S. Equities
History shows that specific sectors of the equity markets are more sensitive to oil price fluctuations than others. For example, the revenue and earnings of oil and gas companies are directly tied to crude prices. We therefore expect the S&P 500 Energy Index of stocks from that industry to roughly track the price of oil.

History also shows that when crude prices change, consumer discretionary stocks tend to move the opposite way (Chart 8). So when oil drops and pump prices fall, investors believe consumers have more money available for discretionary spending, and that extra demand will boost sales and earnings for companies that supply those goods and services. Therefore, we expect S&P 500 Consumer Discretionary Index of equities to outperform the broader market as oil declines.

Since 1990, the year-over-year change in oil prices has roughly tracked the year-over-year change in the relative performance of the energy stock index. During that same time, the relative performance of the consumer discretionary index has generally moved in the opposite direction. These relationships are intuitively satisfying.

However, there have been periods of irregularity within these longer-term price relationships. Right now is one of those times for the consumer discretionary index. Over the last three years, it has moved roughly in tandem with oil prices, the opposite of the long-term relationship. The consumer discretionary index underperformed the broader market by about 5 percent for 2014, even though we would expect declining petroleum prices to boost discretionary purchasing, driving up sales and earnings for index members. In 2013, consumer discretionary stocks outperformed the market by about 11 percent while crude prices rose.

Since 1993, there have been two previous periods during which the consumer discretionary index roughly tracked oil prices, rather than moving in the opposite direction. The first period lasted less than a year during the late 1990’s when the index trailed the broader market while crude fell. The second happened more recently, in 2012 and 2013, as the index consistently outperformed the market, as expected coming out of a deep recession, while oil prices were up and down. The current bout of irregularity started in mid-2014 with the consumer discretionary index underperforming since then as oil plunged. While many things can drive sector performance over the short and medium term (say, one to three years), if the long-term relationship comes back, we would expect the consumer discretionary index to gain with further declines in oil.

Global Equities
The performance of global index funds can be significantly affected by the size of the exposure to certain countries or regions. In this report, we focus on the impact of falling oil prices, so we calculate the importance of net oil exports (or imports) by country to determine which countries may stand to benefit most and which countries are most at risk from falling crude oil prices. We then examine the exposures to these countries for two common global index funds, one developed market index fund and one emerging market index fund.

For developed markets, we examine a  global equity fund, ACIM (SPDR MSCI ACWI IMI ETF). Table 3 looks at the ratio of net oil exports to gross domestic product for countries represented by equities that make up at least 3 percent of the fund. (A negative value for the ratio indicates that the country is a net importer of oil.) In general, we find that the countries represented by shares held by the fund are net oil importers. The largest weight in the fund (54.25 percent of holdings) belongs to stocks of companies in the U.S., a net oil importer.

The only net exporter with a significant weight in the fund is Canada, whose estimated 1,643,000 barrels of net daily shipments abroad represent about 3.3 percent of GDP at $100 per barrel. The weighted average ratio of net exports to GDP for ACIM as a whole is -1.8 percent, indicating that the fund is more reflective of importers than exporters. The aggregate economies of the countries represented in ACIM should benefit from declines in oil prices and be hurt if crude oil prices were to rebound.

Similarly, the emerging market economies represented by a fund that holds shares from those nations (GMM – SPDR S&P Emerging Markets ETF) stand to benefit from reduced crude prices. Emerging market heavyweights Taiwan (14.35 percent of the fund as of January 2, 2015) and India (10.67 percent) are net oil importers that should benefit from falling crude oil prices.

However, Mexico (5.65 percent) and Russia (3.21 percent) are large exporters whose economies will suffer as a result of lower prices. Table 4 below looks at country exposuers and net oil exports for the GMM fund. Like the developed markets fund above, on average, the countries represented by shares held in the fund are actually also net importers, meaning they should also benefit from falling crude prices. However, the emerging markets fund also has exposure to some exporters of crude oil.

Next/Previous Section:
1. Overview
2. Economy
3. Inflation
4. Policy
5. Borrowing and Investing
6. Pulling It All Together/Appendix

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