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Thursday, December 18, 2014

A Black Swan from "Black Gold"

If there was one thing that could not be found among the myriad forecasts for the financial/commodity markets for 2015 it would have been the near 50% drop in oil prices since five year lows:

And if one would have presented the scenario of such a drop in oil prices to analysts and asked them to enumerate the impact on the financial markets. Some predictions would have been relatively easy.'

VDE (energy stocks)

But of course there have been some very very large moves in parts of the financial markets that probably would not have immediately come to mind among analysts. And given the rapidity of the moves it seems clear many were caught by surprise.

Emerging Markets

The massive impact of the decline in oil prices on the Russian currency and economy has been well reported...the impact on emerging market debt and equity indices perhaps less.


I have mentioned before a preference for emerging asia (etf GMF) vs the overall emerging market ETFs like IEMG because of the large exposure to Russia and commodity exporting Latin America. The difference in performance between the two is apparent below.



Emerging market debt indices and thus ETFs have a very high weighting in Rusian debt. And the damage is apparent below in both the local currency emergigng market ETF and the US $ denominated etf (EMB). It is quite interesting that the last time there was a major selloff related to Russian bonds it was in 1998 it primarily involved hedge funds (including the demise of Long Term Capital(LTCM). This time around "mom and pop" retail investors as well as pension funds and others are investors in Russian debt through ETFs or through actively managed mutual funds such as the Pimoc fund reported on in the WSJ which has lost 9% this month.



High Yield Bonds

Companies related to energy particularly oil shale production (fracking) have made up a large proportion of recent high yield debt issuance. Energy related bonds make up 15% of the high yield bond indices. Many of these fracking companies are unable to produce oil profitably at current price levels under $50. Hence fear of future defaults and large drops in emerging market ETFs. Here is HYG the broadest high yield bond ETF.


Even more adversely affected has been HYLD an actively managed high yield bond ETF which has a 30% weighting in energy.


Another area that has sold off is limited partnerships most of them involved in the energy industry. Here below is AMLP the mlp index instrument.

There are several factors that have contributed to make these moves quite large,

  • Time of year as I noted in my previous post end of year markets are prone to low liquidity and volatile trading.
  • Large investment in relatively illiquid markets. The "search for yield" and growth of ETFs and other instruments to allow relatively easy access to what were small sectors of the financial markets has been a two edged sword. On the one hand the investment options have expanded for investors. On the other hand massive amounts of money has moved into what are potentially very illiquid markets...especially when everyone tries to get out at the same time. MLPs , emerging market bonds and high yield bonds all fall into this category,.

The future direction of energy prices is no doubt uncertain and the implications of movements in energy prices will likely have more unexpected consequences in the future,

Bloomberg has a great set of graphics related to the energy markets here


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