Posts tagged Commodity Trends
The Efficient Market Hypothesis, one of the cornerstones of modern financial theory, argues that asset prices always reflect every single shred of information available to investors. Such information, aver EMH’s acolytes, is instantaneously processed by investors through a rational, omniscient, net present value-weighted assessment of probability-weighted future outcomes. Any mispricing between assets and their real underlying value is instantaneously arbitraged away; there are never any $20 bills lying on the street as a free lunch to passers-by.
If the EMH worked as advertised, then the reaction to last week’s presidential election by fixed income yields and industrial metals would have been…well, in our view, not particularly interesting. Instead, the reaction was eye-catching indeed, as shown in the chart below, which forces the question. Do those spikes in copper prices and the 10-year Treasury yield reflect a hyper-rational pricing of all information available to thinking women and men? Or, rather, are they those proverbial $20 bills fluttering along the pavement?
Runnin’ Down a Dream
The meme that took hold almost as soon as Trump uttered the word “infrastructure” in his victory speech was “infrastructure-reflation trade.” Anyone watching the futures market saw this meme go viral as Tuesday morphed into Wednesday. The idea behind this whiplash in different asset classes appears to be: a torrent of federal spending cascading into US infrastructure projects, piling billions onto the federal deficit and igniting an inflationary heatwave. Bond yields would rise (inflation), and industrial metals prices would soar (demand). If this outcome were highly likely, then EMH would be doing its job just fine as assets instantaneously absorbed the news and repriced.
But a more truly rational assessment, in our opinion, would be that this infrastructure-reflation scenario is very, very unlikely to happen. Infrastructure has not been and will continue not to be a top priority for Congressional Republicans. Even if an infrastructure bill were to make its way through the legislative sausage factory, it would be in the end a very watered down version of anything Trump may have promised on the campaign trail. Even then, there would be a significant lag between the passage of any such bill and the formalization of “shovel-ready” projects to be on the receiving end of the funds. Even then, the net impact on headline macroeconomic data points like jobs or consumer prices would very likely be muted for the foreseeable future.
In short, we believe the “infrastructure-reflation trade” is little more than a mirage, a knee-jerk reaction more than a rational expression of future outcomes, and unlikely to be the kind of paradigm momentum shift in asset class trends many observers continue to believe is happening.
Tax Cuts Trump Public Works
The 2016 election does mean one-party rule, and this means an ability to push through economic policy in a way that the gridlocked Washington, DC could not achieve for most of the past eight years. But behind the smiling façade put up in public there are, by our reckoning, two distinct power factions in the Republican Congress with which the incoming administration will have to horse trade. There is Paul Ryan, the House Speaker who probably better than anyone else in Washington knows exactly what he wants to accomplish in the way of economic policy this year. These goals are simple and widely known: tax cuts for the wealthy, and far-reaching deregulation & de-funding with an emphasis on the financial, health care and energy sectors. “Ryanism” is in essence the core fiscal agenda that has motivated Republicans and their conservative donors & lobbyists since the Reagan era. We expect early policymaking to focus nearly exclusively on these issues.
The second power faction, then, are the legislators on Ryan’s right wing flank, the self-styled Freedom Caucus. This bloc would pose a further obstacle to any infrastructure bill that might come out of horse trading between Ryan’s team and the new White House. While the Freedom Caucus is arguably animated more by cultural issues than economic policy, they are strenuously opposed in principle to government spending outside of narrowly-defined defense obligations. The Freedom Caucus is where the “reflation” part of that infrastructure-reflation trade goes to die. Reflation would necessitate the large-scale creation of new, debt-financed money. The votes simply would not be there. The more hard-line caucus members are likely to push hard for dramatic spending cuts even to offset the imminent tax cuts, and there won’t be much left after that for offsetting massive public works projects.
Of course, infrastructure can also fall into the private domain, and there is much animated chatter about private-public cooperation to mitigate the impact of projects on the federal budget. But major infrastructure areas like roads and bridges, that are badly in need of upgrade, generally fall out of the purview of private money, because they do not offer commercially competitive returns. It is unclear how much practical infrastructure could realistically be funded from private investment sources.
Trumpism in the Age of Ryan
None of this is to say that the incoming administration will not have an impact on economic policy choices; by this point it should be clear to everyone that Donald Trump should not be underestimated. The President-elect knows his base; he understands what motivates the legions of voters in Wisconsin, Pennsylvania and Michigan who turned up on Election Day for him. And he will have to show some love to this base. Nothing would render Trumpism a mere historical sideshow than a belief taking hold that their leader is a sell-out who will give the donors and DC elites the keys to the kingdom while they, the base, continue to get the short end of the stick.
To that end, optics will require the new economic policy to be perceived as something more than just the wholesale implementation of Paul Ryan’s narrow agenda of millionaire tax cuts and deregulation. But, as we noted in our commentary last week, the new team is likely to tread cautiously in its first months of occupying the White House. They will perhaps be more likely to find their red meat for the base in other areas – immigration and socio-cultural flashpoints, for example – and more or less let Ryan and Congress hash out and implement their economic agenda.
All of which is to say that, in our opinion, those investors who have been chasing up industrial metals prices and dumping intermediate bonds in these first days of the new order are likely chasing mirages.
To alternately channel-flip between cable TV’s political shows and its business & markets fare is to see a tale of two Americas. On the one there is fever-pitch intensity about, apparently, the end of the world as we know it. On the other, the blood pressure levels of financial news anchors are sedate as they dispense the day’s economic headlines. Risk asset indexes are drifting their way more or less benignly through a season that, in years past, has offered up more tricks than treats. Other than a sentiment that political risk is more or less fully baked into the cake, as we have noted in several recent commentaries, what are the key contributing factors to the apparent glass-half-full sentiment? As always there are many factors at play, but prominent among them is a renewed run of the bulls in oil.
The Soothing Balm of Texas Tea
After stabilizing in the first quarter of this year, crude oil spent much of the ensuing time bouncing between a floor of $40 and a ceiling of $50 per barrel. It managed to test both ends of that range in the month of August, buffeted by conflicting data about persistently high inventory levels, on the one hand, and rumors of a forthcoming production freeze, on the other. Unusually, given OPEC’s notable string of recent failures to achieve anything of substance at their periodic get-togethers, the September 26 meeting on the sidelines of an energy conference in Algeria managed to win the day. A tentative production freeze agreement sent oil prices soaring.
True – the framework production freeze deal announced after that meeting would amount to less than one percent of OPEC’s current output of 33 million barrels per day. Also true – there are still plenty of details regarding individual OPEC member obligations that have to be worked out for the freeze, targeted for November, to take place. But the details do not appear to have fazed investors. Oil producers are taking advantage of the spike in futures prices as far out as December 2018, where prices for Brent delivery are up 36 percent. Spot prices are sustaining their levels above the earlier resistance ceiling of $50. More tellingly, as seen in the chart below, risk spreads between corporate bonds in the oil & gas exploration and production (E&P) sector are less than half what they were in February.
To Market, To Market
While there have been plenty of recent false dawns in the beleaguered exploration & production economy, capital markets seem to be giving the current environment a tentative vote of confidence. Just this past week saw the return of investor interest to the E&P IPO market. Extraction Oil & Gas, a U.S. producer, filed for a $633 million offering of new shares that ended up being priced above the investment bankers’ target expectations. This represents the first initial public offering since 2014; meanwhile, the volume of secondary offerings (i.e. issuance of new equity by companies already in the public market) is $26 billion, making 2016 a record year. Even junk bond investors are sticking their toes back in the water, with a spate of new issues in September amounting to over $1.8 billion.
This flurry of financing activity in the oil & gas E&P sector helps overall market sentiment in a couple ways. First, the opportunity for firms to raise new debt and equity capital allows them to repair their balance sheets and reduce the likelihood of default. And those more forgiving risk spreads shown in the chart above also make the burden of carrying new debt less onerous. So, companies that have made it through the wilderness of the last couple years may be less likely to fold in the coming months or years even if, as expected, oil prices remain well below their highs reached in the middle of 2014.
The Permian Way
Second, at least some of that newly-raised money will be used to purchase new equipment and services as projects become economically viable again. The sharp downturn in energy sector capital expenditures has been a major factor in the dismal performance of the business investment component of Gross Domestic Product in recent quarters. An upturn in activity here should raise confidence in 2017 GDP, which in turn will allay occasional murmurings of a coming recession heard in some corners of the financial commentariat. And there should be more projects to fund than there would have been a couple years ago. Cost structures for U.S. exploration & production companies have fallen by about 40 percent on average during the downturn. Practically speaking, this means that a project that two years ago would have been profitable only with crude oil trading higher than $60 is now profitable at $40 oil. This is especially true in the Permian Basin of West Texas, widely regarded as the most opportunity-rich geography of the domestic oil & gas market and a major investor draw.
There are plenty of risks remaining in the oil & gas sector, and one could argue that investors pouring money into these opportunities now are doing so with rose-tinted glasses. Whether that turns out to be true or not, the perception of stability and improvement in the sector now is, we believe, helping to grease the wheels of risk asset markets heading into the final stretch of the year. A yawningly boring October, should it continue for stocks and other risk assets, may be the tastiest treat of all for investors’ Halloween bags.
As July came to a close the chatter among oil price watchers in the financial media was about the onset of “bear market territory” as Brent crude prices fell some 20 percent from their recent June highs. That might have been newsworthy were the asset in question Dow Jones or Nasdaq stocks. But crude oil? Another day, another radical price swing. There had already been four corrections of 10 percent or more, followed by snapbacks of an equal or greater magnitude, between the beginning of the year and Valentine’s Day. More recently, spot Brent crude prices spiked by nearly 20 percent between early May and early June as US production continued to slow, outages in Canada, Nigeria and Libya hit supply volumes, and Saudi Arabia promised its OPEC peers that it would not flood the markets with new product in efforts to grab new market share.
Reality Bites Back
Just one month later, reality proved to be somewhat different from June’s rosy picture. Saudi production in July spiked to a record level of 10.67 million barrels per day, contrary to its earlier promises of restraint. The Middle East is baking in a massive heat wave, with temperatures spiking over 120 degrees and air conditioners cranking up and straining local energy company supplies. Elsewhere, though, demand in key markets including the US, China and India waned. A big contributing factor to waning demand has been record high downstream inventory levels. In recent years, oil refineries in the US and elsewhere turned up gasoline production volumes as low prices pushed consumers back into their beloved gas guzzlers of yore. This has resulted in record inventories for the refiners and thus reduced demand for new crude supplies.
Finally, in addition to higher Saudi supply and lower global demand, the supply cuts from outages in Nigeria and elsewhere abated and volumes kicked back into gear as those situations resolved themselves. Hedge fund managers took stock of these developments in late July and decided they didn’t like what they saw. Brent crude plummeted from over $45 to $40 from July 21 to August 2 as speculators reversed their earlier optimistic bets. Market commentators channeled their best inner Yogi Berra to proclaim “déjà vu all over again” as prices failed to sustain an upside breakout. The negative view was subsequently reinforced by a new International Energy Agency report, published earlier this week, forecasting 2017 demand levels to be lower than previously expected.
Hope Springs Eternal
Those factors – continuing record levels of production alongside weaker global demand and in particular a downstream inventory glut – would appear to be fairly stiff headwinds. So what accounts for the 10 percent price spike since August 2 and, in particular, the 5 percent jump in Brent October futures that happened yesterday? Stop us if you’ve heard this one before…a possible OPEC production freeze! We got a news tidbit from OPEC at the beginning of this week that there would be an “informal” meeting of cartel ministers on the sidelines of an unrelated energy industry conference scheduled to take place in September. That sparked an immediate bump in spot and futures markets.
Then came the IEA report, mentioned above, with its dour outlook on demand, to temper animal spirits. Never fear! On Thursday, comments from Saudi energy minister Khalid al Falih were “mistakenly” released to journalists, in which the minister expressed his belief that coordinated action among OPEC members could help balance oil market conditions. Yes, you have indeed heard this one before. There was a similar amount of hype and speculation leading up to the OPEC meeting in Doha, Qatar, back in April. As with yesterday’s remarks, there were plenty of conditionals and weasel-words in the pre-Doha communiqués, and in the end nothing got done at that meeting. No freeze, no productions cuts, no nothing.
We are highly skeptical that anything more lasting will be accomplished on the sidelines of September’s sideline confab, either. Even if OPEC’s beleaguered small-nation producers managed to convince the Saudis to go ahead and back a production freeze – a very big and unlikely if – we would not see that as having a dominant and lasting effect on the structural supply / demand problems the industry continues to face. Meanwhile, integrated oil producers continue to wrestle with the double-whammy of low price realizations upstream and strained margins downstream. Big Oil continues to face an environment of Big Problems.
Our Annual Outlook will be published next week. Below is the executive summary.
2015 was a key transitional year in capital markets. In the US the year signified the end of an era. From 2009 through 2014 US equity markets grew at an average annual rate of 12.6 percent largely due to the efforts of the US central bank – the Federal Reserve – to stimulate markets through a combination of zero-level interest rates and outright open market purchases of fixed income securities. The Fed wound down QE (quantitative easing, the term for its bond-buying programs) in 2014. At the end of 2015 it raised interest rates for the first time since 2006, albeit very gently. With the training wheels of monetary policy stimulus coming off, US stock markets returned last year to a focus on fundamentals. For better or for worse, we expect that trend to continue in 2016.
The economic backdrop in which US equities will perform this year is little different from the trend of the past couple years. The economy is growing, albeit modestly in comparison to historical norms. We are close to what economists would consider to be “full employment”, with the strongest consecutive periods of job creation since the late 1990s. Upward movement in wages is still elusive, though it bears mentioning that wage growth did slightly outpace inflation in 2015. Consumer spending, which makes up the lion’s share of US GDP, continues to grow although there was a general sense of disappointment with the 2015 holiday season. We see little reason to believe that GDP will grow by more than three percent this year or by less than one percent. Overall, US economic fundamentals should remain favorable this year.
Elsewhere in the world the story is quite different. The European Central Bank launched an expanded monetary stimulus program early last year, extended the terms of the program yet again towards year-end, and is expected to do more again this year to lift Europe out of its economic funk. China is also contending with the realities of slowing growth and looking for ways to manage a very tricky economic rebalancing away from investment towards consumer activity. In essence, the global economy’s path is diverging, with the US on one track and the rest of the world on another. The related uncertainty suggests the potential for more volatility than we have seen in recent years.
The aforementioned China rebalancing looms large as the year gets under way. The world’s second largest economy continues to grow, if not at the double-digit levels to which it was accustomed in the previous decade. Retail sales and other measures of activity are healthy. But slowing growth is a concern for a variety of reasons. China’s non-financial debt-to-GDP ratio is approximately 250 percent. A sharp growth contraction could have a negative knock-on effect among other Asian economies. And China has the potential to roil international credit markets if it feels compelled to sell off large amounts of FX reserves (mostly US Treasuries and other sovereign debt) to prevent a currency rout.
At the same time, China’s shift away from the massive public and private investment programs which drove its earlier phase of growth has major implications that reach far beyond its own borders. In particular, the growth boom of 2000-14 drove a massive commodities supercycle. It will likely take a very long time for the energy and industrial commodities which rode the boom to approach anything close to their peak prices. In the meantime, stabilization at lower trading ranges is the most optimistic case for a wide range of commodities in 2016. Resource exporters from Brazil to Australia and Russia will feel the pain. And companies in the energy and mining sectors will continue to deal with downsizing, project cancellations and, in some cases, potential for debt defaults.
As headline-grabbing as China’s predicament is, the situation is more dire still in other emerging markets. Brazil and Russia, which alongside China and India make up the once-dynamic BRICs, are both in protracted economic and (in Brazil’s case) political crises. Other erstwhile engines of growth from Turkey to South Africa, Malaysia to Indonesia, have seen their currencies collapse by the largest amount since the 1997 Asian currency crisis. Dollar-denominated debt obligations remain a potent overhang. And with weak demand seemingly a chronic feature just about everywhere, opportunities to export one’s way out of trouble seem limited. Emerging markets as an asset class has disappointed for several years; we do not see that changing significantly this year.
How will the monetary policy divergence noted above affect interest rates in 2016? The short end of the yield curve is probably more predictable. The spread between US and Eurozone yields, with the latter firmly ensconced in negative territory, could widen further still if the Fed sticks to its plan of gradual rate hikes. The intermediate/long term is subject to other variables, not the least of which is the potential for foreign central bank sales of US Treasuries to support their beleaguered currencies. Finally, expect credit quality spreads to be a continuing story in 2016. The sorry state of resource sectors like exploration & production and mining has taken a toll on the high yield market. But spreads continue to widen as well between higher-and lower-rated investment grade securities. Tightening credit conditions could also have an effect on corporate decision-making. Stock buybacks and M&A, both of which rely heavily on debt financing, could feel the impact of more stringent credit conditions.
X-factors – our shorthand for latent risks that could turn into live threats – abound in 2016. The Middle East, never the world’s most calmest region, looks less stable than ever. Europe faces a potential humanitarian crisis as refugees continue to arrive in droves. In the US, the Presidential election reflects a sharply divided and dissatisfied populace, with the potential to throw out the playbook on the usual rules of the game. Russia’s foreign policy adventurism continues apace. These are just a few of the prominent potential threats we know; there very probably are others. Always remember, though, that X-factors can be both positive and negative. Market sentiment can change very quickly as the landscape changes.
In summary, we believe 2016 will likely be a year of trend continuation rather than mean reversion, with dominant trends like monetary policy divergence, a strong dollar, commodities prices and uncertainty about China shaping the sentiment. We expect US equity markets to be strongly influenced by earnings. Rationally, that would imply the potential for price gains in the low single digits. However, as bull markets get old – the current one is in its seventh year – rationality often gives way to volatility. Volatility can work on both the upside and the downside – melt-ups are as common as melt-downs. We believe the right response to the uncertainty of this environment is to remain diversified across a spectrum of low-correlated asset exposures, and to avoid large concentrations in any given area.
Credit is due to the Yellen Fed for setting clear expectations and then delivering on them. Markets expected a 25 basis point increase in the target Fed funds rate, accompanied by an accommodative policy statement, and that is just what they got. “Monetary policy remains accommodative” was the key phrase in that statement, underscoring the reality that data trumps calendar when it comes to the size and timing of policy actions in 2016.
Nonetheless this is something of a brave new world, a definitive coda in the policy-driven economy of the past seven years. There are plenty of risks as well as opportunities in the year ahead. Here are five observations informing our thinking as we see out 2015.
#1 – Sell the Rumor, Buy the News
Counter-intuition was a theme in many asset markets in the immediate lead-up to and aftermath of the 12/16 announcement. Asset classes that typically fare poorly in rising rate environments, such as precious metals and high dividend stocks, were strong outperformers on the day. The dollar was mostly muted against other major currencies. Most likely, expectations were largely baked into prices well in advance of Wednesday and thus the news itself gave little reason for further action. If anything, the trading dynamic Wednesday afternoon was characterized by some holiday bargain shopping in recently oversold corners of the market.
#2 – Ignore the Short Term Noise
We expect to see higher than average volatility prevail through the remainder of the year, and we attribute this to little more than the residual noise following a major policy event. The S&P 500 opened Wednesday morning at 2043 and closed Thursday afternoon at 2041, with this net return of zero punctuated by an aggregate spread of three percent over the two day period. The two year Treasury yield is at a five year high, while the ten year still sits below its average over the same period. We do not see much in the way of meaningful trend signals coming from the market until this residual froth settles, and recommend riding out the volatility to the extent possible.
#3 – Inflation is the New Jobs
The big event on macro calendars for the past several years has been the jobs report – “where for one brief moment the interests of Main Street, Wall Street and Washington align” as the Wall Street Journal likes to say in its first Friday of the month live blog. We’re not sure that the mid-month Consumer Price Index report will earn its own following of econo-journalist fanboys and fangirls next year, but it should. Assuming that the prevailing employment trend doesn’t go into sharp reverse, we expect that prices will be the key variable influencing the size and timing of future Fed action. The FOMC policy statement released Wednesday made repeated mention of near-term and long-term inflationary readings and progress towards the 2 percent target. Although reasonably balanced, we give somewhat more weight to the possibility for a faster than expected pickup in prices (outside the volatile energy and food sectors). It may be time to dust off those TIPS for portfolio inclusion.
#4 – The Fed and the Spread
While the Fed has occupied the spotlight for much of 4Q15, the real action in 2016 may be less in future rate hikes than in risk spreads between Treasuries and other fixed income asset classes. It is always worth remembering that risk spreads have a direct effect on household financial decisions through mortgages, personal loans and the like. High yield spreads have taken a hit recently, in part due to another wave of commodity price slumps, but we would be more concerned about investment grade spreads as a wild card that could inflict collateral damage on other asset classes. The Office of Financial Research (OFR), an independent office of the Treasury Department whose annual Financial Stability Report should be required reading for anyone invested in global asset markets, calls out “elevated and rising credit risks in the US nonfinancial business sector” as a key area of potential weakness. US companies have benefitted greatly from historically cheap borrowing costs in the past five years, serving up dividends and buybacks and other things investors hold near and dear. Those good times may be nearing an end.
#5 – Commodities: More Pain, but Stable
Speaking of commodity price slumps, we have listened to a number of quarterly earnings calls from energy companies over the past couple months. In expressing their views on 2016 the dominant theme is an impersonation of Rocky 2’s Clubber Lang: “My prediction? Pain”. The supply-demand imbalances that have sent crude prices down to seven year lows this year will not work themselves out overnight. Nonetheless, the impact of US E&P downsizing should start to be felt and inventories should gradually recede from their recent record levels. Demand should improve as well, with China a likely buyer of more oil at lock-in price levels for its strategic petroleum reserves. While we do not see a return to fortune and favor for commodities in the near term, we also do not necessarily see commodity prices as a key risk story for 2016. In our most-likely scenario model we have modestly narrowed our crude price range to $40-55 from $40-60.
There are plenty more blips on our radar screen: emerging markets, corporate earnings, geopolitics and US elections – among others – are all in the mix, set to surprise, befuddle, delight or antagonize investors in the year to come. We will have plenty more to say about all of them. Happy holidays.