Four Theories on How Oil Has Hypnotized the Global Stock Market

Even casual observers know oil is exerting uncommon influence on stocks. What’s less clear is how the energy market has come to dominate sentiment in industries with seemingly no connection to crude prices.

Understanding why oil is casting such a spell is more than an academic inquiry. The reason matters, given how big the moves have been. Almost $1.6 trillion has been erased from U.S. stocks in 2016. If oil is contributing, it’d be nice to know why.

Here are four theories on what’s underpinning the connection. They range from a straight economic signal to speculation oil’s plunge threatens to lay low everything up to and including the financial system. None is authoritative — it can’t be — and it’s possible that something else entirely is only making it seem like oil and stocks are moving in lockstep. But these are the hypotheses most often cited by equity investors this week.

1) The Economy

Theory: oil traders have sussed out information on the direction of the global economy and the plunging price reflects a world hurtling into a recession. U.S. stocks have taken note, or have drawn the same conclusion on their own.

“Oil is a proxy for global demand and growth and there’s a real view that as prices move it’s reflective of the global economy,” says Michael Arone, the Boston-based chief investment strategist at State Street Global Advisors’ U.S. Intermediary Business. “Who’s leading who is perhaps hard to tell here, but it certainly seems both are indicating concerns about the world economy. ”

Skeptics would say oil’s fall is an overproduction issue: the demand side has yet to wane and signal a collapse in global growth. Still, coupled with fears of China’s shrinking appetite, bears persist in pinning oil’s plunge to concern about demand. The S&P 500 lost 0.7 percent at 9:59 a.m. in New York, as oil slid 4.3 percent after weak Chinese data.

2) Credit

Theory: The price of crude underpins the value of so many corporate bonds and loans that its 57 percent decline since June will ignite a crush of defaults that bankrupt hedge funds and banks. Energy makes up a fair portion of riskier bonds: 19 percent of the Bloomberg High Yield Index, or $284.1 billion.

“The major risk banks have is not to their normal retail-oriented stuff, it’s to the oil space,”  says Andrew Brenner, head of international fixed income at National Alliance Capital Markets in New York. “Shale drillers and various oil situations have made up an increasing amount of high yield lately, and banks have lent a lot of money to energy, so you have the high-yield loop and you have the financials loop.”

Default rates in the oil patch could reach as much as 15 percent this year, with the overall corporate default rate rising to 7 percent, according to BCA Research Inc. That’s almost double the pace of the mid-1980s, when an oil price correction sent energy sector defaults soaring. Furthermore, energy companies are on the hook for $190 billion, or 2 percent of all bank loans, according to BCA.

If prices stay sub-$30 a barrel, smaller energy companies that borrowed money to finance projects may be unable to repay their debt or funnel cash to shareholders. There’s fear of contagion beyond energy and financials: banks could react by tightening credit lines, thus magnifying the credit crunch. That fear fuels a broader selloff in equities.

3) Investment

Theory: Energy and commodity companies do so much hiring and building in the U.S. economy and when they stop, earnings will suffer both within and outside of the industry.

“The energy space was the fastest growing part of the U.S. economy post-financial crisis and now it reverses. Businesses are shuttered and people are laid off,” said Nick Sargen, who helps manage $46.2 billion as chief economist and senior investment adviser for Fort Washington Investment Advisors Inc. “There are some people beginning to worry that this thing could spread like the subprime crisis. People had said then that it was too small to matter, and then you find out there are linkages you didn’t know about.”

Although cheap oil is theoretically a boon to stores and restaurants, equities take a bigger cue from business spending, much of which is tied to commodities. In 2014, the energy sector accounted for nearly one-third of S&P 500 capital expenditures, according to data compiled by Bloomberg. The average energy company spent $5.7 billion on capex that year, compared with an average $1.5 billion in the overall index.

Jobs in fields such as drilling, fracking and rigs make up 0.4 percent of total U.S. employment, and 1.6 percent of real value added, according to BCA. Investors are concerned that energy’s contribution to the U.S. economy will evaporate as oil sinks, said Sargen.

4) Pain trade

Theory: The world’s biggest investors are being forced to sell everything that isn’t nailed down to offset the hit they are taking on their crude holdings. After getting pummeled in commodity trading, investors may be stepping into stocks and unloading.

“If you have a multi-asset portfolio and you’re looking to de-risk and you have problems in one sector, you’ll attempt to sell others to get your overall risk profile lower,” says Krishna Memani, chief investment officer at Oppenheimer Funds Inc. in New York. “Credit markets were tanking, oil markets tanking and equities were at their highs so where do you go to reduce risk? You go to equities.”

One big seller may be oil-rich nations from the Middle East to Latin America, which account for about 5 percent to 10 percent of global assets. After years of using oil money to buy assets, now they’re selling them, sending petrodollars pouring out of investment vehicles like sovereign-wealth funds, stabilization funds, development funds, and foreign-exchange reserves sitting in central banks.

The gross flow of petrodollars into the global economy last year fell to as little as $200 billion, down from nearly $800 billion in 2012, according to Royal Bank of Scotland Group Plc. Bloomberg