Could the crude oil market bust spell trouble for high-flying U.S. stocks?

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Could the current slump in crude oil prices to historic lows mean the U.S. stock market’s recovery since late March is fragile ?

That’s a question some are asking as the disconnect between downbeat commodity values and high-flying equities in the past month puzzles investors trying to figure out which market will ultimately prove right on the U.S. economy. If energy markets are correct, equities could succumb to gravity and give up the gains seen since March 23.

The implosion of crude oil markets in the past week holds a mirror to the broader distress in the U.S. and global economy.

Social distancing measures imposed on consumers and business shutdowns enforced to combat the spread of the coronavirus pandemic have led to a collapse in international trade and travel. Gasoline and jet fuel prices have sunk as a result leading to crude oil inventories rapidly filling the available storage space.

The lockdowns have also led to a slump in business revenues and consumer spending, causing mass unemployment in the U.S. not seen since the 1930s, at least temporarily. The issue for business earnings, economic growth and stock market values is that the U.S. is more dependent on consumer spending than some other economies.

SeeJobless claims jump another 4.4 million — 26 million Americans have lost their jobs to the coronavirus

“It shows us that the reality of demand destruction in the economy is more dire than what other risk asset prices, particularly U.S. equity prices, reflect,” said Lauren Goodwin, economist and multi-asset portfolio strategist at New York Life Investments, in a Thursday note.

Yet equity investors are looking past the current corporate earnings slump in anticipation of economic growth rebounding later this year, as the lockdowns are slowly lifted and recently announced massive government and Federal Reserve fiscal and monetary stimulus recharges demand.

SeeU.S. budget deficit will expand to almost $4 trillion this year, CBO says

Crude oil prices have fallen to 20 year lows, with the now-expired Nymex May contract for West Texas Intermediate crude CL.1, +1.41% falling into negative territory and settling at -$37.63 a barrel last Monday. The move, in thin trade, underlined how the oil glut has squeezed available storage, with traders, in this instance, paying others to take crude off their hands out of fear there would be no place to park it in Cushing, Oklahoma, the delivery hub for Nymex crude futures.

“You’re running into a situation where all that supply has to go somewhere,” Michael Ponikiewicz, portfolio manager at Acadian Asset Management, told MarketWatch.

Yet the U.S. benchmark S&P 500 SPX, +1.39% stock index is up around 25% from its March 23 low, according to Dow Jones Market Data. The benchmark gained 1.4% on Friday, but ended with modest losses this week.

The stock market may have shrugged off the oil slump though in part because the direct hit from low oil prices is limited for Wall Street.

The overall share of the energy sector in U.S. equity and even in corporate bond markets is minimal, and many fund managers have steered clear of the industry due to the challenging economics of crude production and the growing adoption of more carbon-friendly investment approaches in the U.S. and abroad.

Energy represents less than 3% of the overall S&P 500 index, and around 12% of the index for sub investment-grade corporate bonds.

“You have many markets that are very much looking through this near-term malaise,” said Chris Hoffmann, portfolio manager at Thornburg Investment Management, in an interview.

The slide in crude oil prices also reflects quirks unique to commodity markets, complicating any analysis using energy prices to deduce the U.S.’s economic prospects, said Hoffmann.

Though oil demand shrunk rapidly due to the coronavirus pandemic, the price war started by Saudi Arabia and Russia began the slump in oil prices, and producers have been slow to shut down drilling rigs to help supply match the collapse in demand.

Even with the recent production cuts from a coalition of oil exporters including OPEC, crude producers may still need to cut as much as 20 million barrels a day, said Ponikiewicz, citing figures from the International Energy Agency.

“The oil market is on its knees,” said Tim Magnusson, senior portfolio manager for Garda Capital Partners, told MarketWatch.

ReadThe oil market is running out of storage space and production cuts loom

Yet crude’s malaise isn’t limited to the most recent oil futures contracts where storage issues can have a pronounced impact on prices and thus diminish their economic signal. U.S. crude futures set for delivery as late as the start of next year are also trading at less than $30 a barrel.

Crude oil prices may offer a worrisome signal on the health of U.S. economic growth, but they also jibe with the pessimism embedded in the bond-market, often considered a superior indicator of the real economy’s prospects than stock prices, said Magnusson.

He noted expectations for consumer price inflation over the next decade implied by trading in U.S. Treasury inflation-protected securities, or the 10-year breakeven rate, stood at 1.10%, well below the Federal Reserve’s inflation target of 2%.

More poor corporate earnings reports next week may test the equity market’s recovery in the past month too.

Google GOOG, +0.23% , Microsoft Corp. MSFT, +1.82% , Facebook Inc. FB, +2.66% , Apple Inc. AAPL, +2.88% and Amazon.com Inc. AMZN, +0.44% all report in coming days but are seen as potential beneficiaries of the lockdowns that are forcing consumers to work from home and shop and entertain themselves online. Those five stocks alone represent about 20% of the S&P 500’s market capitalization. Other stocks may not be so lucky.

In U.S. economic data, the first snapshot of first quarter growth will be published with GDP data on Wednesday. Weekly jobless claims, the ISM manufacturing activity index, and consumer spending data are also among the highlights for the week ahead.

The Federal Reserve will also be in the spotlight at its Wednesday policy meeting but after the massive monetary stimulus and credit guarantee programs the central bank has announced in the past two months, new initiatives from Fed chairman Powell are seen unlikely.

SeeHere’s a breakdown of the Fed’s rescue programs to keep credit flowing during the coronavirus pandemic

Originally Published on MarketWatch

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