Observations by David Robertson, 6/16/23

Blah blah CPI, blah blah FOMC, blah blah retails sales, blah blah initial claims, blah blah. Yes, the week had a lot of economic news. No, none of it changed the market’s mind on anything.

As always, if you want to follow up on anything in more detail, just let me know at drobertson@areteam.com.

Market observations

As shown by @SoberLook, the VIX/MOVE ratio reached its lowest level since 1996, reflecting a stark contrast between stock investors’ calmness and rates investors’ relative unease. The depressed VIX may well be part of the decidedly disinterested reaction of stocks to the news flow this week.

The fact that stock volatility is so extremely low relative to bond volatility also points to vastly different worldviews by the two markets. Since the Fed is administering monetary policy through rates, and therefore the fixed income market, it is fair to judge that policy effects are being reflected there first. Since stock markets are driven mainly by flows, it is also fair to judge those prices aren’t saying anything useful about the economic landscape - other than that flows are still coming in.

Credit

Opalesque Risk Briefing: Debt Ceiling Déjà Vu?

https://www.opalesque.com/webinar/

The main subject of this webinar was the phenomenon of credit spreads being exceptionally narrow given weakening economic fundamentals. Mike Green addressed the issue head-on. His take is there has been “reduced issuance” despite an upcoming “sizable maturity wall”. No transactions = no price discovery = spreads mean nothing.

Another really interesting insight he provided was an analysis of rate effects on companies. At current coupon rates, which are well under market, 90% of companies are profitable. However, at current yield-to-worst (YTW) rates, only 40% of companies would be profitable. If you go out to expected YTW rates, only 7% are profitable.

So, this is the new, expanded crop of “zombie” companies. Most of them really can’t refinance their debt because if they did so, they wouldn’t be profitable. As a result, they wait, and hope, and pray, that something changes - like a massive Fed pivot. Because if it doesn’t change, they are cooked.

One takeaway is the credit environment is a whole lot worse than rates currently let on. The potential for a lot of debt-burdened companies to go under over the next couple of years is extremely high. Another takeaway is passive debt funds can’t do anything about it. As long as money keeps coming in, they will keep putting more money into this crop of the walking dead.

Oil

HUBBERT'S PEAK IS HERE

http://gorozen.com/research/commentaries/1Q2023_Commentary

Global demand in 1Q23 surpassed 102 mm barrels per day -- three million barrels above the 1Q19 (pre-COVID) level and almost 2 mm b/d above the International Energy Agency’s (IEA) 1Q23 estimate.

From here on out, just six counties in West Texas must meet all global demand growth. Given the strategic importance of the Permian, it’s imperative to understand its underlying health. Using our neural network, we have updated our basin analysis, and the results are shocking. The Permian is likely less than a year from peaking and starting its decline. The only source of non-OPEC supply growth is now primarily tapped out.

Great commentary on commodities as always by Goehring and Rozencwajg. One point is oil demand is fairly strong. Not only is it well beyond pre-Covid levels, but it beat Q1 estimates handily. The big demand question is, “How much will global demand slow down later this year?” Current oil prices are implying “quite a bit”, but it’s a moving target.

At the same time, the supply side is continuing to get tighter. Most estimates I have seen plug in pretty decent growth for US supply. G&R show how narrow and how limited US supply growth opportunities really are. The risk of a slow down in Permian growth is even greater given the increased productivity of wells. As rig count goes down, production drops disproportionately.

The main message corroborates what I have been saying for a while now: Supply growth opportunities are declining at the same time global demand is continuing its inexorable rise. Longer-term, this should be very bullish for oil prices. Shorter term, investors have to figure out how much slower economic growth might impair demand. All this while Saudi Arabia and the Biden administration are acting like two kids in the back seat of mom and dad’s car taking turns punching each on the arm.

Gold

In Gold We Trust report 2023

https://ingoldwetrust.report/?lang=en

The geopolitical showdown around the reshuffling of the world order is already in full swing. The structurally higher demand for gold from central banks will be a key driver of the gold bull market.

I commented two weeks ago, “One of the big changes in the gold market … is the rapidly increasing purchases of gold by central banks. Not only are gold purchases increasing, but they are also increasing as a percent of foreign reserves. In other words, gold is displacing other currency reserves. This is what is meant by “structurally higher demand”.

This phenomenon helps explain another one. Historically, the price of gold moves inversely with the real interest rate. This can be seen in the chart from longtermtrends.net/. The relationship makes sense since real rates represent the opportunity cost of holding gold - because it doesn’t provide any kind of yield.

So, the other phenomenon is the increasingly disparate relationship since early 2022. For the last nearly year and a half, gold and real yields have moved away from each other, not with each other. Although this doesn’t make sense purely from the standpoint of opportunity costs, it does make sense in the form of incremental purchases from central banks. No longer is gold just an asset to buy when real rates are low; now it is an asset central banks feel compelled to buy in order to rebalance their reserves.

The one line takeaway, then, is, “Structurally higher demand” can be a powerful force! Even as higher rates continue to weigh on gold prices in the short-term, central banks and others foresee a bigger role for (and therefore greater demand for) gold well into the future.

Macro strategy

A BETTER STRONG DOLLAR MODEL ($)

https://www.russell-clark.com/p/a-better-strong-dollar-model

Most classic currency models (at least the ones I use) would have suggested dollar weakness for some time now. One of my favourite measures, Net International Investment Position (NIIP),  worked well at signalling a dollar top in 2000 when liabilities rose above assets, and a dollar bottom in 2010 when assets caught back to liabilities. However, this model has been bearish the US dollar from at least 2016.

I am beginning to think NIIP has changed, because the nature of investing has changed. If we look at the shares outstanding of the S&P 500 (S&P 500 market cap/ S&P 500) we can from the dot com bust through to 2011, equity market RAISED capital. But since 2011, equity markets on the whole have RETURNED capital. This accelerated in 2017, just as US NIIP also blew out.

This piece by Russell Clark pulls together a number of loose threads for me. For one, it provides a unique argument for the strength of the US dollar (USD). The short answer is the Net International Investment Position (NIIP) worked well for modeling currencies for a period of time, but became ineffective as large US corporations started returning capital and accumulating large cash balances (Treasuries) offshore.

Another interesting insight is the trend of broken economic and financial relationships. NIIP worked just fine for quite some time, but then low interest rates and tax incentives for companies to keep cash offshore disrupted the information content of NIIP. There is an increasingly voluminous swath of economic relationships that used to work well but stopped some time over the last fifteen years - mainly due to excessively low interest rates. The one I am closest to, equity valuation, counts among them.

Finally, and paradoxically, just as we are getting more and more access to cheap data to analyze, the models and analysis are becoming less useful for various reasons. Clark goes so far as to say the changes in the investment landscape imply “old school macro analysis is largely useless”.

This is probably true, but I also think it overstates the case. I absolutely believe the current landscape is treacherous for analysts who naively compare conditions today to the past in search of similar information content. That said, as the low rate era migrates to a more normal rate era (relative to history), I expect many of the old relationships to return. That suggests “old school macro analysis” will start working better again and many of the tools of yesteryear will reassert their value.

Analyst tips

Re: Oil/Investing - Lessons From The Oil Patch / Will Atlas Shrug? ($)

https://www.urbankaoboy.com/p/re-oilinvesting-lessons-from-the

Cyclical stocks, especially Commodity Cyclicals, can have their Micro/Fundamentals swamped by adverse Macro developments.

A rising commodity tide floats all boats — even very poorly managed ones with terrible geology, but watch out when the tide goes out!

Even if you get the big picture Macro and company-evel Micro right, you can still get blindsided by Regional and Geopolitical Black Swans!

I have a folder in Evernote labeled, “Analyst tips”, which is intended as a resource for new analysts. This post by Michael Kao serves the same purpose - along with some entertaining stories and useful insights into the energy industry. I found most of the lessons to comport well with my own experiences in the industry so I thought it would be helpful to post some of the highlights here.

One of the things that immediately strikes me about Kao’s writing is his temperament: He is not only willing to talk about mistakes, but seems to embrace the opportunity to learn from them. This is a very good sign, and an exceptionally rare one. Great investors are always learning.

Another point is one of the fastest, and cheapest, ways to learn is to study other people’s mistakes. While I firmly believe you need to invest/trade real money in order to really learn, reading and studying other’s experiences is a great accelerator. Further, the lessons from one industry or corner of finance often has parallels elsewhere.

Risk management

Storm Cycles ($)

https://www.mauldineconomics.com/frontlinethoughts/storm-cycles

“In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point.

“What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.”

One of the patterns I have noticed over the years is the better risk management strategies tend to be almost philosophical. For a young analyst embroiled in a rapidly changing market, they often come across as distant, disconnected, and probably not relevant any more. Over the years, I have also learned how often this arrogant and self-absorbed perspective is wrong. I made that mistake plenty of times.

John Mauldin’s comments in this week’s letter discuss several of the better risk management perspectives. The sandpile example, in particular, provides some especially helpful insights.

One of those is, “even the greatest of events have no special or exceptional causes” In other words, there is no identifiable catalyst. In a world in which everyone is working to identify patterns and relationships, this might be a surprising discovery. It means much of that work is pointless in terms of identifying risk.

This relates to another insight: The potential magnitude of a risk event “has to do with the perpetually unstable organization of the critical state". In other words, risk is a function of underlying conditions, not specific causes. It is a function of weak foundations. This is why I almost always spend time discussing the investment landscape. Alternatively, environment and climate conditions also serve as apt metaphors.

When you start looking for situations with “perpetually unstable organization of the critical state”, you start seeing them all over the place.

Landscape

One recent example stands out. The regional banks that went under, SIVB, SBNY, and FRB, each suffered from a similar set of conditions. Each loaded up on longer-term Treasuries when rates were exceptionally low. Each also had large bases of uninsured depositors.

It doesn’t take a rocket scientist to figure out if rates rose (which they did), the value of longer-term Treasuries would get hit hard. Nor does it take a rocket scientist to figure out if a bank’s equity is severely threatened, its uninsured depositors should move money out ASAP.

As a result, it wasn’t any surprise to people who follow banks closely that higher rates hurt all banks and these three banks were especially at risk due to the nature of their depositor base. Weak foundations.

A similar story can be told about high yield bonds right now. And commercial real estate. And private equity. And venture capital. And stocks. And on and on. Of course these things are risky and of course there is a lot of downside. They cannot withstand rates remaining higher for longer. Again, weak foundations.

People who are adding positions in these areas are not “leaders” and are not seeing something others are not. They are simply being what I’ll call “risk obtuse”; i.e., being intentionally stupid about taking on risk in hopes they will once again get bailed out.

In short, the organization of the critical state is perpetually unstable for many sectors, primarily those involving debt. That means any little thing can cause the sandpile to collapse - because the foundations are so fragile to begin with.

Implications

While FOMO continues to be the ethos of the stock market, it is becoming increasingly clear that rates are the tool by which policymakers are trying to reset the financial and economic system. Given the extensive range of maturities, however, the magnitude of damage to fixed income markets will be determined not so much by how much higher rates go (though there is room for more increases), but how much longer they will stay high. Now, it’s mainly a waiting game.

Effectively, this will cull the herd of highly indebted and poorly performing companies. With some luck and targeted interventions, it will do so without causing major systemic risk to the herd at large. Without some luck, things could get pretty ugly.

One implication is the weak ones will be left to fend for themselves and will be vulnerable to the ravages of higher rates. As a result, I suspect there may finally be some opportunities to short specific securities for those who are so inclined.

Another implication is passive credit funds have no means by which to avoid this fate. As long as money continues to flow into the funds, these funds will have to direct the money into companies that will be unable to refinance existing debt. Investors might take more pleasure from burning the money themselves. Sad days for passive, but good days for active.

Finally, a more general implication is that a change in guard is beginning between investors and company leaders who always chase risk and those who adeptly manage risk. When interest rates are zero, or can be expected to get there shortly, there is little cost of taking risk. When rates are more normal, as they are now, there are real costs associated with taking risks. That means it is once again a valuable exercise to identify and manage risk in this environment.

For many, it will take time to figure this out, especially those who have never experienced the need for risk management in their adult lives. They will need to change and adapt or be among the weak members of the herd that get culled. The good news is this means that skills like strategic planning, risk management, effective operations, collaborative work, and knowledge development will all become much more valuable again. Yay! This is excellent news for everyone who works hard and creates value! Bad news for those with little more than a “vision”.

Note

Sources marked with ($) are restricted by a paywall or in some other way. Sources not marked are not restricted and therefore widely accessible.

Disclosures

This commentary is designed to provide information which may be useful to investors in general and should not be taken as investment advice. It has been prepared without regard to any individual’s or organization's particular financial circumstances. As a result, any action you may take as a result of information contained on this commentary is ultimately your own responsibility. Areté will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. 

Some statements may be forward-looking. Forward-looking statements and other views expressed herein are as of the date such information was originally posted. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Areté disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.

This information is neither an offer to sell nor a solicitation of any offer to buy any securities. Past performance is not a guarantee of future results. Areté is not responsible for any third-party content that may be accessed through this commentary.

This material may not be reproduced in whole or in part without the express written permission of Areté Asset Management.

Share