Is The Oil & Equity Correlation Signaling A Shift In Supply-Side Sentiment?VW Staff
Is The Oil & Equity Correlation Signaling A Shift In Supply-Side Sentiment? by Rashad Ahmed
Rising Correlations and Oil’s Equity Beta
The rising correlation between crude oil and U.S. equities has been getting quite a bit of attention lately (here and here etc). Though estimates are near highs, correlations haven’t surpassed levels seen during the European Sovereign Debt Crisis or the Global Financial Crisis of 2008, meaning we may not be at the top of the staircase just yet.
The relative risk between oil and equity prices captured by oil’s equity beta, however, is at record levels. Meaning on average, stock price sensitivity per unit move in oil (and vice versa) is at all-time highs. Historically, the correlation and beta between crude oil and stocks tend to rise during periods of market stress and crisis, e.g. when demand-side risk heightens. Equities and oil share similar demand-side risk profiles, as capital seeking (fleeing) risky, inflationary or pro-growth investments flow in (out) of both asset classes. Given the current macroeconomic environment, uncertainties on the demand-side from continued Fed tightening, deflationary headwinds, and currency devaluations/stronger USD will continue to weigh down on both assets. Still, these extreme levels of co-movement do not sustain themselves, and as markets calm down correlations and betas subside back towards historical averages.
The mean-reverting behavior of current correlation and co-volatility levels imply that these two assets will break away from their current lock-step behavior – at some point. Fundamentally, this may be signaling that a shift is coming in crude oil’s supply-side risk sentiment. Relative to equities, crude oil bears greater sensitivity to supply-side risks, as an unexpected inventory build in petroleum products naturally impacts crude oil prices directly while equities typically experience diminished second order effects due to index exposure to energy, etc.
Shifting Supply-Side Risks
While the demand-side risk profiles of the two assets appear aligned, they behave differently when observing supply-side dynamics. With the majority of negative supply-side sentiment priced into both equities and oil (the excess return of oil over equities has been this negative only 3 times in the past 26 years), an improvement in supply-side factors is not far from a reality when considering rumors of coordinated OPEC and non-OPEC supply cuts coupled with rising geopolitical risks in the middle east (bullish for oil). This shift in supply-side sentiment will give crude oil favorable upside risk versus equities, while both equities and crude oil maintain similar downside risks, making crude oil a more attractive investment, ceteris paribus. The likelihood of a signaling shift in supply-side sentiment associating with a reversion of oil-equity correlation and beta is imminent. Given that (option – implied) volatility spreads between the two are abnormally wide, a shift in sentiment would trigger a tightening of the spread (e.g. relative risk, and therefore in the oil-equity beta and correlation would realize a reversion) – sparking a rally in the oil-equity excess return thanks to the decoupling of the lock-stepping price action observed in current state.
These views on oil-equity outperformance can be expressed by purchasing crude oil exposure and shorting a broad U.S. stock market index against it in a dollar neutral portfolio, or shorting crude oil volatility against a long equity volatility position.