We used to believe that while some things may be sustainable in the short run, ultimately either math, sentiment, or reason would prevail. Thus we were guided by the mantra: Whats inevitable might not be imminent but it is inevitable. This line of reasoning covered Fundamental valuations, Government finances and Central Bank policy. I am now going on record as stating that our views on the inevitability of certain things has changed, possibly forever. One singular reason leads us to this conclusion: our definition of what is inevitable is based on historically based precedents and precursors, some of which represent severed causal relationships which may never be re-established. Fundamental Valuations: Valuations of capital assets involved an assumed risk free rate of return, when risk free rates involve negative signs, all valuation metrics are rendered moot. Governmental Finances (Deficits Matter): The recent JV between the Treasury and The Fed virtually ensured that deficit spending will continue unabated, regardless of which party occupies the White House. Fed Policy: The JV between the Fed and The Treasury, necessitated by the law which prohibits The Fed from buying private assets, will drag the Central Bank further into the political realm. MMT and other “costless” solutions to the problems that mostly receive only passing concerns anyway will suddenly become more and more accepted and promoted. As economic “reality” becomes less tethered to what we previously thought was considered sustainable, investors should seek shelter in those things that cannot simply be created by fiat, i.e. Hard Assets.
Having watched the commodities markets for well over 30 years, we used to believe that there was a certain methodology that one could apply to investing in these sectors based on shifts in industry capacity. In brief, when price rose, this would send signals to the market to add capacity, which inevitably would lead to over capacity and to falling prices, setting the stage for the cycle to repeat itself. In this scenario, decisions to expand or contract CAPEX were solely driven by the price of the underlying commodity as access to capital dictated as much. However, as we have discussed at length, in a post GFC world, Central Banks and capital markets in general have severed the relationship between rent seeking yield and the actual return generated on that dollar of investment. In short, the incremental yield of return necessary to finance growth has compressed to such an extent that the profitability of that growth has become almost irrelevant. However, the convergent forces of a global pandemic combined with ESG considerations have possibly brought a new return model to the global oil industry, one which we may see migrate to all commodity businesses. The decline in the relevancy of the industry has been well documented, but this decline increasingly represents a point of no return (pun intended). In a world where environmental concerns shorten the long term runway for its very survival, oil E&P companies are now legitimately transforming themselves into what we would typically think of as a basic utility. In this new business model, growth seeks to mimic the growth in the underlying demand for the commodity (2-3% in the case of oil) with any excess cash flow generated by outsized returns resulting from above average crude oil prices distributed to shareholders via discretionary dividends.
A decade is a long time for a teachable moment, but maybe we only “get it” during times of pandemic, the “it” being the one primary truth that price, and price only, matters. While this may not seem revolutionary, particularly for us who espouse the philosophy of the contrarian always willing to buy or sell consensus if that consensus is not consistent with the true fundamental picture. Of course the true fundamental picture is open to interpretation and perhaps that is where our lesson begins, the true fundamental picture is dictated by price action and not the other way around. Over the last ten year period (some might argue longer, but we are only choosing to focus on the last decade) price action has created its own fundamental reality. George Soros has termed this process reflextivity, in short an environment where price creates its own set of divergent fundamentals. The reflexive nature of markets over the past decade has progressed to such an extent that it has become wholly ingrained in investors psyches. What we are describing is not simply momentum investing but rather an alternate reality driven solely by the movement in price. While this action is clearly seen in individual sectors and names (Tesla comes to mind) , it is seen in the action of the market as a whole; as evidenced by the recent divergence between public capital markets and the broader underlying economy. Explanations for the increase in reflexivity are many but we maintain that monetary policy focused almost solely on smoothly functioning capital markets lie as the primary culprit. For the time being, let price and reflexivity rule; that is until the alternate reality converges with real world consequences.
With a good number of states loosening their SIP orders, financial markets have definitely weighed in on what will await them: Pent Up Demand. While we concur that the sudden release from an imposed lockdown will incite the need for dining out (albeit at a distance) and some form of retail therapy in whatever form is allowed. What we have a problem with is that Wall Street has not fully taken into account the fact that the absolute carnage caused by the sudden and total cessation of global economic activity has yet to even really be felt yet. As folks tiptoe back into the workplace (to the extent that they have a job) and to this new life as we know it, it will become apparent that the fallout from this pandemic has yet to unfold. I just read a statistic that the job losses in March and April alone were equivalent to all the job losses experienced through all the recessions in this country combined since 1960. If this is not stress-inducing enough, look at the SP500 banking index which is struggling to put in a bottom since the “April Lows”. Clearly the banking sector is anticipating that there will be some credit losses associated with this event. One can recall that in the early parts of 2008, the consensus was that the concerns in residential real estate would be minimal and relegated to one small part of the mortgage market; a notion which was wrung out of investors psyches over the ensuing three years. It seems to us that things will be different for the global economy as it tries to regain its footing, post lockdown. We find it non-sensical to believe that what we return to will be relatively unscathed by the events of the last 3 months, particularly given the tenuous state of the global economy heading into 2020.
I’ve been thinking a lot about runways lately, probably because we’ve been inundated with images and descriptions thereof: namely empty actual airport runways and the runways companies and countries are going to need to exit this latest exogenous shock. Just as with their aeronautical equivalent, companies and countries are vigorously trying to find the lift and the length of ground necessary to safely exit this pandemic without a violent ending. The problem is that the lift (stimulus both fiscal and monetary) is being applied to an aircraft weighed down by a multitude of existing mechanical problems. While we have no reason to believe that the aircraft won’t get off the ground, the length and success of the ensuing flight is not assured, something you would never know if you look at the equity markets YTD. As we have written about before, the efficacy of Monetary Policy globally was on the wane going into this crisis, and certainly there is nothing to make us believe that Central Banks, even in concert with relatively unrestrained fiscal policy, will provide nothing more than a brief bounce in growth. We also have no doubt that anything less than a V shaped recovery will quickly be met with a multitude of Central Bank countermeasures, none of which will be effective. Fade the V, Buy Stuff.
Welcome to the Asynchronous Reality Show, a term( full disclosure not coined by me unfortunately) used to describe the cognitive dissonance currently exhibited by some parts of the Capital Markets, particularly public equity markets. The gap between reality and perceived reality is commonplace on Wall Street even in normal times, and one has to remember that $7Trillion in stimulus ($3Tln Federal Government and $4Tln in Fed Backed and unbacked purchases) makes for one hell of a party.
However, a glance at the chart shows what one might term the real economy as measured by the S&P GSCI commodity (denominator)index versus the S&P (numerator), lets call it the hope and a prayer versus the ugly truth chart. The sharp increase in the chart would infer that investor hopes (aided by that friendly $7Trillion) aren’t paying much attention to the bloodbath in the real economy, most notably the action in Crude Oil.
Physically unable to perform (PUP) is a term thrown around training rooms, generally to describe players whose injuries are not severe enough for the injured reserve list but still are incapable of playing at that particular time. The term could also be used when looking at the recent debacle in the crude oil markets. While commodity related ETF’s and ETN’s have been around for awhile, they have always had issues when the shape of the underlying futures curve forced some type of disconnect in the publicly traded vehicle. While we maintain that the move into negative territory for spot oil was going to happen (and was happening already) sooner rather than later, the illiquidity of an expiring futures contract into a spot market short of prompt storage simply pushed the inevitable along. The lessons learned from the action on Monday are many, but the main takeaway should be : Financially constructed proxies involving physical delivery of actual commodities are rife for manipulation and extreme dislocation, particularly when the product has been sold to a public unaware of its particular nuances.
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If you thought the the MMT drivel died with the Sanders candidacy, look no further than the weekend FT interview (access above). Some of the comments from this interview were virtually mind blowing. The discussion could have not been more apropos as legislators scramble to throw more money at the slowdown precipitated by the global pandemic. While we are of the opinion that it is the job of Government to step in and provide support for situations exactly like this; namely sharp exogenous shocks to the economy with the potential to be both socially and economically destabilizing. What we take issue with is the notion that mechanisms and programs at both the Central Bank and the Treasury level are “free”. The thinking embodied in this article could only be seen through the lens of a global financial system held captive by Central Bank behavior.
The old adage of “low prices cure low prices” may be tested over the coming months as prices in some oil producing regions of North America are dipping into negative territory. The bottlenecks all across the supply chain in energy, mostly as a result of the complete decimation in energy demand, have led to prices no one ever rationally envisioned happening. While storage restraints and other practical capacity limits will ultimately ring fence price (at some level), we question what the trajectory of recovery will look like in a post pandemic world. The alphabet soup of oil demand recovery (W,V,U,L) nomenclature will probably not be robust enough to encapsulate what will undoubtedly be indescribably unique due to 1) Massive shifts in unemployment, most of which may be permanent 2) shifts towards more work at home employment 3) Lasting effect on travel both work and leisure 4) Shift towards more balkanized supply chains. All of the aforementioned will lead to a murky energy demand picture for years, not quarters, to come. Thus the new adage may be” Only no prices cure low prices”.
Developments in the crude oil markets pre and post- pandemic are quite indicative of just how much supply and demand dynamics are almost immediately reflected in price. Compare and contrast this to the way that pricing is taking place across almost all of credit of late, with the introduction of The Fed as active buyers. As you may know, Crude Oil is a world-wide, fungible (generally) product whose utility is derived from its coincident products of gasoline, diesel, jet fuel, naphtha, etc.. For the most part, crude is extracted, transported, processed, and consumed in a relatively tight time frame given the just-in-time nature of both production and usage. The market is remarkably balanced in the way that dislocations in one part of the global supply chain are almost immediately reflected in sub-sections of the market, which in turn incrementally affect the global price. Because of this balance, shocks to the system such as the recent global pandemic cause even systemic safety valves to be strained to their limits, as is the case with global storage which sits at roughly 2 billion barrels. Overproduction by both the Saudis and Russia in the face of a cratering of demand has pushed global storage capacity to its limits and is projected to reach capacity over the course of the next 6 weeks, causing exactly what supply and demand would dictate: Price of crude oil falling to generational lows, some landlocked crude even falling into negative territory. Contrast this with the Corporate Credit market whose price response to this sudden risk event was predictable in its its arc in that certain parts of the credit world fell over 30-50%. We say predictable in that as we have been pointing out for months, credit was priced for perfection and whatever just happened could at best be termed less than perfection. However, unlike the physical crude markets where price was allowed to find its natural level, the Fed rode to the rescue albeit under the guise of the Treasury as per its Charter it is not allowed to buy private assets. So, in addition to backstopping the commercial paper markets, the Fed now was stepping up and buying corporate bonds, Commercial Mortgages and a whole host of other credits whose bids outside of the Fed were non-existent. While this activity may be debated as to its merits,(I personally find it appalling particularly when just 6 months ago the same people begging for these programs now extolling the merits of Capitalism and decrying the evils of Socialism) lets be clear that these moves will do nothing to improve the conditions surrounding the underlying credits. Pure price discovery for some, socialization of losses and pain for the many (taxpayers ultimately).