With the US election now behind us, markets are back to the more mundane task of focusing on the economic landscape (aka “bad news”). As should be quite obvious at this point world growth has lost momentum over the past few months and many leading indicators suggest a further slowing in growth in the coming months. I have seen no data that suggests a turning point in the economic cycle, the environment for riskier assets is likely to remain challenging in the near term. Given all this negativity I am inclined to believe we are more likely to face a severe overshoot to the downside which would result in a more V-shaped recession, I think this will actually be good as it will allow us to reach a true bottom and not stay in purgatory like the Japanese markets have for the past 20 years. The bottom line is that the signs of weakness in the US have spread.
The key issue now for markets is whether global policymakers will be successful in stopping the economic rot. Alongside further monetary easing, the re-emergence in policy deliberations of (expansionary) fiscal policy as an instrument of macroeconomic policy is a very encouraging development. Signs of a trough in the global IP cycle would be an important sign that policymakers are winning the tug-of war and in turn would be catalyst in changing some recent near-term trends, both in the world economy and risky markets. The weakness in the industrial growth cycle, particularly outside the US, has been an important contributor to recent market concerns about the growth outlook. Better signs here would normally be consistent both with firmness in global equity markets and some underperformance in bonds. It is personally my opinion that the US will have to offer substantially higher rates on the longer-term bonds that need to be offered to fund current budget deficits; this will inevitably further benefit those who are smart enough to be engaged in bullish steepeners. Steepeners are used to bet that the yield curve will be steepening (hence the name). Simply put, I believe the yield curve will steepen as the government will pursue numerous expansionary policies further driving our country into debt which will force the government to offer higher yields as in the long-run (i.e. many years from now) our currency will surely drop to a level that is more commensurate with the inherent risk associated with a deeply indebted country.
This actually brings me to one of the points I wanted to make today. On an absolute basis, both equities and credit look inexpensive. P/E ratios are at their lowest levels since the early 1980s and credit spreads are at historical wides. While current valuations have been driven by a bleak fundamental outlook, including the potential for declining earnings and rising defaults, risk aversion and liquidity have also played a major role. Both credit and equity look good relative to government bonds (this goes back to my steepener thesis). Limited liquidity has been an important driver of cash credit spreads, due to mark-to-market losses, lack of available funding, tighter risk budgets, and redemptions. Other asset classes, also affected by severe liquidity problems, also appear to offer very attractive valuations. While equities have also been challenged in this respect, liquidity problems have been less severe, however there are special situations, i.e. stocks with mass hedge fund concentration. Credit spreads may move even wider as default rates rise. Similarly, equities are unlikely to stage a sustainable rally until closer to an inflection point in economic activity. Moreover, as credit markets have been at the center of the financial turmoil, it is unlikely that equities can stage a meaningful recovery before credit markets, which in turn requires liquidity conditions to improve. Equities have de-rated against bonds. European equities are down close to 50% since their peak, erasing most of the gains since 2003 (or 1997, for that matter). Equities have not only performed badly in absolute terms, they have also underperformed bonds for most of the last 15 years. Equities usually lag the credit markets and as the credit markets have yet to improve I would be surprised if equity could improve. I would therefore recommend that investors seriously look at investing some capital in high quality credit and the reserve a portion to play in the equities market this way they could benefit from both turns.
Now I would like to take a moment to speak about that cowboy market that is energy. Oil prices and returns continued to decline sharply in October as negative macro sentiment accelerated and as the severe slowdown in economic activity resulting from the credit crisis – evidenced by plummeting manufacturing surveys around the world – has substantially weakened physical oil fundamentals and prices. In particular, substantial weakness in the Asian petrochemicals sector has prompted a collapse in petrochemical margins, which has weighed on refining margins, likely motivating a reduction in refinery utilization in Asia.
This weakness in petrochemical demand is also occurring in Europe, exacerbating downward pressure on the Atlantic Basin gasoline market as naphtha (a colorless distillation product) that is not being consumed to make plastics is being re-directed into the gasoline pool. On net, the recent weakness in petrochemical activity is further weighing on the US gasoline market, which is already plagued by a combination of weakening motor gasoline demand and increasing ethanol production. This gasoline weakness is hindering the recovery of US refinery runs after the hurricane season, further reducing the demand for crude oil. Going forward, expect low demand for crude oil by refineries will likely continue to exert downward pressure on crude oil prices. While the announced 1.5 million barrels OPEC cut could counter weak refinery runs providing support to prices, the full implementation of the cut is not likely within the next couple of months, underscoring the downside risk to crude oil prices in the very near term. That being said I think the long-term price of oil will settle at the marginal cost of production which last time I checked is in the $60s now and is expected to go to around $75 by 2010. The reason for this increase is all the easy wells are already drilled. This forces E&Ps to move to more difficult locales, like tar sands or deep offshore drilling, these are expensive places to drill land as such require oil prices to be higher. Although oil is a waning resource it will be kept in check by developments in alternative fuels (which last time I checked are realistically 20+ years away from mass implementation). It should be noted that I am not recommending buying E&Ps but I think there are some real values in the pipeline MLPs which can be found to yield in the high single to low double digit dividends and have locked in business for years to come. This is where I would be focusing my attention.
In summary I recommend people take a look at steepener swaps (or other comparable ways to play a steepening yield curve), and be ready to pounce on values in both credit and equity markets, paying particular attention to MLPs with locked in business. On an aside, I want to apologize for the brief post, work has been quite all encompassing as of late and I have barely had time to go grocery shopping let alone craft a veritable in-depth investment thesis worthy of posting for public consumption, hopefully over the upcoming Thanksgiving holiday I will be able to devote some more time to this.