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).
The New F Words
Forbearance and Force Majeure are two words that will suddenly become synonymous with the economic fallout from the Coronavirus. As we wrote earlier, this period is difficult to characterize given the sudden nature of the decline in cash flow across almost the entire economic landscape. Its as if the lights went out and everyone literally is fumbling around in the dark trying to find their way. Lifelines from Governments are always clunky, unwieldy and slow to implement, so don’t look to this most recent bailout to stem what is going to be a virtual tsunami of workouts coming down the pipe. As we have said repeatedly over the last few years, credit fueled markets, constantly backstopped by Global Central Banks were rendered more and more unstable. That instability is unfortunately coming to the forefront, and the recent trillions of misplaced Government dollars won’t be enough to stop it.
What The L
With no other analog in modern economic times, outside of World Wars, the global economy has come to essentially a standstill. Central Banks and Governments have done what institutions do in crisis mode, which is throw money at the perceived problem. I say perceived problem because unlike the GFC this is a system-wide problem which is going to exact consequences on every single facet of the economy. There is no ring-fencing the economic fallout from this crisis and looking at the stock markets as a barometer of what the tail end of this will look like is foolhardy at best. The one similarity that I would concede to the GFC is that much like 2008/2009 we are now seeing the hidden risks that were not so hidden. In our Jan 17th post we wrote about a possible feedback loop occurring when illiquidity from one part of the capital markets triggered responses from other disparate sectors, well little did we know that not 60 days later this would happen writ large. However, Fed actions to address this illiquidity have far surpassed anything we saw with the GFC, with asset and Treasury purchases totaling around 85Bln per month in 2008, the current program is seeing 125Bln in miscellaneous Fed purchases per day. This is the ultimate in QE infinity. In addition to The Fed action, Central Banks in conjunction with Governments across the globe , are committing significant funds to combat this crisis, even Germany has allocated 750bln Euros to stem the financial losses associated with the pandemic: note they committed next to nothing during the 2008/09 GFC. In short, real funds are being directed in real time to combat what should be considered a multi-headed structural crisis: medical, financial, and Governmental. My point in all of this is that unlike 2008/09, this crisis is truly more systemic, more far reaching, and more sustainably damaging to global growth. Any thoughts of a V recovery should be tossed aside in spite of recent pronouncements of a return to “normalcy”. Our new normal will look nothing like our most recent past, particularly given the tenuous nature of the global economy heading into this crisis. When thinking about what the next 6-12 months will look like, Forget the V, Expect a W, and Fear the L.
With the advent of the Coronavirus, we of course get introduced to a new term ” Social Distancing”. Basically, this is a new term for staying home, working from home, and generally avoiding large groups in order to avoid contamination. This kind of risk avoidance, along with market movements of late, got me thinking about how Central Banks have attempted to quarantine markets from all exogenous risks over really the last 12 years. The cordoning off came under the guise of low rates and no matter the risk, market participants could rest assured that a shot of liquidity was at the ready. In Nassim Talibs book Antifragile he does a great job describing systems that become inherently more unstable as they are overly engineered to become more stable. This could not describe todays environment more perfectly, in attempting to eliminate all systemwide risk, even those associated with a normal business cycle, the entire system has been rendered more risky.
OPEC +’s decision to walk away from any volumetric cuts in response to a steep coronavirus-driven decline in demand did not necessarily come out of left field in spite of what you might read in the days ahead. The seemingly unrestrained production coming from U.S. non-traditional shale has long been a source of frustration for other producers who have stood by and watched the U.S. take precious market share. While they may have been comfortable piggybacking on the production discipline of others, the irony of the recent flaring controversy could not have been lost on the global oil players, particularly the Russians. Picture this: An OPEC meeting discussing the need for cuts in production butting up against a report last week describing the flaring of gas in the U.S. as seemingly out of control, literally restraint versus the un-restrained. Well, in light of this weeks events, the problems of restraint seem to have been solved.
Was listening to someone describe how the quality of literature and the written arts used to be better primarily due to the fact that, prior to the introduction of the personal computer, everything had to be typed on a typewriter. The manual labor involved in such an undertaking simply left more white space on the page than had one been using a PC. That white space was a definitive statement that what was on the page deserved to be there, if not only for the work involved with whiteout or correction tape. The contrast now is that we live in a world with no white space, technology (for good or bad) allows for no uninterrupted narrative, all “information” all the time 24/7. In the absence of white space, story fills the page, right or wrong, true or false, the vacuum gets filled. The result is Tesla, Virgin Galactic (SPCE), Beyond Meat, Wework,etc.. The aforementioned are all filler and no substance, they represent a need on the part of the investing public to fill in the blanks of actual fact based fundamental analysis with story. In fact, story stocks resemble reality TV, the exact antithesis of white space, all drama, no backstory or context and the glorification of immediate gratification through a rising stock price.
We knew that the details attached to the phase I deal signed in January didn’t hold up to even the flimsiest of scrutiny, primarily due to a not insignificant little clause thrown into the agreement: as market conditions warrant. With the outbreak of the coronavirus, welcome to the Phase I backdoor. If truth be told however, this agreement was all about face- saving to begin with and the proof is best shown in the price action pre and post-signing. If you look at what was touted as the major beneficiary of the deal: agriculture (particularly soybeans) you can see that the market itself held little faith that China would ever come through with purchases of the size promised, particularly with a huge crop coming from Brazil and a severely weak Brazilian Real. Market conditions, in the eyes of the Chinese, is synonymous with cheaper elsewhere and one can rest assured that the price deterioration produced by the slowdown in global supply chains will virtually ensure that this weak agreement produces almost no new net gains in trade.
Friends Without Benefits
Now that Brexit is a fait accompli , meaning The U.K. is leaving the E.U. at some time, with some rules and will pay some of its EU related debts, at some future determined time. In short, Brexit is an agreement to break up with your girlfriend but that the party doing the breaking up is finally realizing that this actually has real consequences. Michael Gove has” told businesses that export to Europe they need
to prepare for “significant change” with “inevitable” border checks for
“almost everybody” who exports to the EU from next year.” Lest there be any confusion amongst those that would suggest that there will be an imposition of soft borders only starting in 2021, Gove stated
“The only way in which you could avoid those customs procedures and regulatory
checks would be if you were to align with EU law and if you were to align with
EU law we would be undermining the basis on which the prime minister secured
the mandate at the general election to affirm our departure,”
So, the messy divorce continues with the only details to be ironed out are child support, maintenance, visitation rights, etc., in short everything.
Make Delusion Great(er) Again
The new decade has proven quite the breeding grounds for new and different events that threaten the bounds of credulity. Having just witnessed the SOTU last evening, one delusion that has been perpetuated over and over again, only to be ultimately reconciled, with falling (usually steeply) prices is the delusion that the economy and the capital markets are one and the same. The Donald loves to perpetuate this delusion as it is simplistic and can easily be explained to him in pictures and crawls at the bottom of Fox News. The plain facts are that capital markets and economic fundamentals can diverge, and often do so for extended periods of time. We are going through such a time, but how could this not be the case, we have just encountered phenomena never, ever experienced in the history of advanced economies namely: coordinated and planned central banking, planned and manipulated interest rates globally irrespective of normalized growth and the institutional acceptance of moral hazard. Simply reflect on this one statistic when you think that things are going so swimmingly with the real economy : Since 2007 Global Debt has gone up by $128Trillion while Global GDP has gone up by only $27 Trillion. To put this in more simplistic terms, it has taken almost a five fold increase in leverage ( and thus systemic risk) to generate one incremental dollar of global economic growth.
The crowd at Davos this year seems to have fallen in love with another social platform: ESG. (Ignoring the obvious criticism of a group that on the one hand pounds the table for climate change while leaving the conference on over 300 private jets) While we admittedly have come late to the party on gauging the impact that ESG has had on investment behavior, what we don’t buy into is the fact that hype and loosely written pacts and agreements lead to faster and greater acceptance on the part of a society that has to live with and pay for these changes. Whether it is conflict minerals or the unacceptable use of plastics across a number of consumer markets, or a basic anti-carbon sentiment, the tide is clearly turning against allegedly the most “egregious” of sectors: the commodity/natural resources space. However, as with most trend shifts, there is a initial groundswell of support as the trend takes hold. However there is also much confusion about: how will it affect the consumer, who will ultimately pay for it, what is the governments role in monitoring its use, substitutability of use among non-controversial inputs/elements. The turning point within the seismic shifts that we are talking about involve an immense amount of noise as industry, governments, special interest groups, media, and social media all conspire to create a distorted time line for acceptance of the new normal. We’ve already seen this with investment flows co-opting the time frames for certain “eco-metals” like lithium and cobalt, and for companies like Tesla and others. What investors have to understand is that these anticipatory capital flows simply create an entire new cycle of pre-adoptive over-investment. It is this over-investment that ends up distorting the real fundamentals for some assets and asset classes, and obscuring the possibly still attractive fundamentals for the others considered off limits by either the court of public opinion or select investment committees.