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.
Sunday, November 16, 2008
Sunday, November 9, 2008
Interesting economics analysis
I wanted to write a post about how I thought the Fed was running out of options and we were most likely headed for a longer recession than the government would like, but then I found this paper which quite frankly is much better than anything I could have written, so please read and enjoy....
Economics Getting to the End of the Rate Cut Road Hatzius 2008-10-31[1]
Economics Getting to the End of the Rate Cut Road Hatzius 2008-10-31[1]
Get your own at Scribd or explore others:
Saturday, November 1, 2008
Emerging Thoughts
Before getting into this week’s post I just want to comment on this past week. Last week I spoke about the temporarily insane valuation of VW and how it was easy money to short it at 90 like it was temporarily during the past week. Well have I got good news for you, on Tuesday Volkswagen surpassed ExxonMobil to become the world's biggest company by market cap after Porsche announced plans to raise its stake in the German carmaker to 75% from 42.6%, triggering a short squeeze. As of Oct. 23, almost 13% of Volkswagen's shares were on loan, mostly to short sellers who were forced to swallow massive losses and exit their positions. The ADR traded as high as 225 on Tuesday which is a full 400% from last Friday’s (10/24) close of 53. They traded down the rest of the week to end at 122. Let me preface this by saying shorting is very risky and by nature has an unfavorable risk/return slope. That being said if you are a fundamental value investor, it is not very hard to see that the current price on VW is absolutely insane. Anyone who knows there financial history can see that this is a modern day corner and that fundamentals have been thrown out the window. For those with a strong stomach join SAC and Greenlight and try to ride VW back down to where it should be in the 30s.
In other economic news real GDP fell -0.3% in Q3, better than economists' -0.5% consensus, according to advanced estimates. Last quarter it grew 2.8%. The largest contributors to the downturn were lower prices for nondurable goods and a deceleration in exports. While the GDP shrinkage was more modest than expected, things will likely get worse before they get better. The key to this is GDP is a lagging indicator and the recent GDP number does not represent the pain seen in October or the pain we will see in November and December. I am not saying the markets will fall, I am saying spending will fall on a YOY basis. Although this may be painful for retailers and the economy in the near term I can think of nothing better than U.S. consumers tightening their purse strings and hopefully reducing some of that outstanding debt, not to mention I would love to get our savings rate up there, remember counting on social security to support you in your golden years is a fool hardy proposition.
One thing that is becoming starkly obvious is the stimulus package has not succeeded as many had hoped. It is slowly becoming more evident that another stimulus could possibly be needed. Another large stimulus in the range of $200bn + will be needed to offset the sharp drop in spending relative to income by US households and businesses (i.e., the increase in the private sector financial balance) that is now underway due to the tightening of financial conditions. If left unchecked, this retrenchment raises the risk of yet more adverse feedback effects between the real economy and the financial sector.
Aggressive government responses could limit the impact of the adjustment (in other words no action is clearly the wrong action) both directly via the fiscal boost and indirectly by stabilizing expectations and financial conditions. What is technically worrying about this is that the US budget deficit is already quite large and any further leveraging might damage the system (i.e. our old nemesis inflation might rear its ugly head). But taken in perspective this objection is misguided because it ignores the greater cost of letting the downturn continue unchecked. Net-net I think we will see our federal deficit continue to climb until we see substantial government action. Remember the Federal Deficit equals the sum of private sector surplus and net-foreign capital inflow. Although it is just an accounting identity, this equation has the following, very powerful implication: An increase in the private sector balance must raise the government deficit by the same dollar amount, unless it is offset by a reduction in the current account deficit. Historically higher private sector balances have been a bad thing. In principle, it would be nice to see a package that offsets the entire negative impulse to economic activity since further increases in unemployment – from a level that is already well above what’s needed to control inflation are – a pure social “bad”. In theory, one might argue that this requires an increase in government spending on domestic goods and services of 4% of GDP or a tax cut – which inevitably involves some “leakage” into increased imports – of 6% of GDP. In dollar terms, this would imply a massive $600-$900bn stimulus. Either way I would bet the next administration does something within their first month of office (that’s if something doesn’t get done sooner).
The recent weakness in emerging markets has raised concerns in developed markets about the overall impact on profits as well as the specific risks to companies with high revenue and net income exposure to EM. In general, until very recently, the highly exposed companies have outperformed the broader market and their more domestically exposed counterparts. However, the sharp reversal of performance in these stocks being seen currently reflects the growing concern about further EM activity weakness (For an illustrative example see IBM or YUM). While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.
Earlier in the year emerging markets were seen to as a pillar of stability since the credit crunch started to emerge in the summer of 2007. Three key factors were at play. Firstly, emerging market banks were seen to be relatively unaffected by the deepening crisis in the US mortgage market, secondly emerging markets were continuing to weather a slowdown in export growth as domestic demand remained robust, and thirdly most of emerging markets benefited from higher commodity prices as they were commodity producers. With the fall in commodity prices and the worsening of the global credit markets EM indexes and stocks have fallen sharply. Emerging countries typically have had limited access to USD funding in proportion to their IMF quota. The Fed, however, on October 30, 2008 announced that it is extending dollar swap lines to the central banks of Brazil, Mexico, Korea and Singapore so as to boost USD liquidity in those emerging markets. The swap lines amount to US$30 billion for each central bank. These swap arrangements allow central banks in the major countries to provide liquidity to their local banks without having to deplete reserves or tap the normal FX market. However, if central banks in the other parts of the emerging world want to provide their banks with USD without impacting the normal FX market, they have to use either their reserves, turn to the IMF or look at less orthodox measures such as capital controls. These fears have made it more difficult to roll over existing liabilities in global capital markets and even harder to issue more debt, putting pressure on countries that do not have enough liquid assets to offset the shortage in foreign liquidity. Asian countries are less exposed to this risk relative to Eastern European countries, Latin America and Asian economies that have recently come under pressure (like Indonesia and Korea) rank somewhere in the middle in terms of exposure. The growing focus on the vulnerability of Central and Eastern European economies has been reflected in weakening currencies in the region, prompting several EM central banks to tighten liquidity either by intervening in the FX markets (and reducing reserves) or through higher overnight rates (for example the National Bank of Hungary raised rates by 300 bps, while overnight rates in Romania reached a peak of 500% last week). Weakening currencies have two major impacts. First, Eastern European countries have borrowed in foreign currencies and will face higher repayments when their national currency weakens. Second, for foreign companies exposed to this region, they will have lower profits when they translate them in their reporting currency. Growth expectations for the region have come down aggressively. While Russian GDP growth accelerated to 8% in 2007-2008H1, the pace of activity had already slowed before the banking crisis hit. The slowdown started on the back of a rapidly tightening labor market and widespread price pressures. The banking crisis has significantly added to the problems. Despite significant injections of liquidity into the banking system by the Central Bank of Russia and Finance Ministry, inter-bank lending has ground to a virtual halt over recent weeks with significant negative impacts on banks funding. Working capital constraints have emerged and anecdotal evidence suggests this is causing stoppages at a number of manufacturing facilities; this will ultimately result in starkly lower productivity. On top of the risks to growth, several countries in the region have needed to turn to the IMF for financial support. While Iceland and the Ukraine have already negotiated broad packages with the IMF, Hungary reached an agreement with the IMF for a package amounting to US$25.1 billion (including €6.5 billion from the EU and €1 billion from the World Bank). Interestingly, in contrast to what we saw in the Asian crisis, the programs have less conditionality than in the past. These are likely to be supported by at least some extension of liquidity support from central banks in advanced economies through the expanded use of swap lines and similar instruments. Together these should boost investor confidence and trigger a return of capital inflows. However, the sheer size of the external funding requirements in these countries means that some may still have to experience a sharp contraction in import demand.
While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, high EM-exposed banks and telecoms have only recently started to underperform the broader market and their own sectors. In both cases, however, the recent falls seem to have overshot their peers in emerging markets. Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Amongst this group basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.
The real question in my mind is when the developed markets calm are the EMs going to be the first to “pop” back up? As the world is painfully learning, the problem with leverage is that it is much easier to create than to reign in. Banks can, in effect, create leverage out of thin air. For example, when a bank makes a loan, it creates both an asset for the borrower (the proceeds from the loan) and a liability (the obligation to repay the loan). However, if the bank wants to reduce its leverage, things are not so easy. The bank can either wait until the loan is repaid (which can take a long time) or sell the loan to a third party. And even if there is a secondary market for such a loan – and recently such markets have become increasingly illiquid – selling the loan does nothing to reduce overall leverage in the financial system. This is because of the iron law of finance: for every buyer there has to be a seller. The liquidity that the bank gets from selling the loan is offset by the liquidity lost by the party that purchases the loan. But this creates an obvious problem. If most institutions are trying to delever at the same time, then asset prices must decline until enough investors with sufficient liquidity are lured back into the market. Needless to say, this dynamic has the potential to be particularly damaging to emerging markets (as we have seen over the past few weeks). On balance, the question of whether we see another full-blown EM crisis (i.e. worse than it is today) will hinge on the speed and vigor of the policy response. Thus far, the response from policymakers has been encouraging, which suggests to us that a baseline scenario in which all but the most levered EMs face a soft-landing is still the most likely outcome. That being said I think it might be time to look into the best positioned EM. I personally am most fond of Brazil as I think they have the cleanest balance sheet and should benefit from either their strong natural resources or/and their buoyant domestic economy.
Hopefully next week I hope to present a stock idea, I know I have been saying this for some time, problem is I am finding a lot of flaws in numerous ideas so I have yet to find one that I am comfortable presenting. Rest assured I will find one, so keep reading.
In other economic news real GDP fell -0.3% in Q3, better than economists' -0.5% consensus, according to advanced estimates. Last quarter it grew 2.8%. The largest contributors to the downturn were lower prices for nondurable goods and a deceleration in exports. While the GDP shrinkage was more modest than expected, things will likely get worse before they get better. The key to this is GDP is a lagging indicator and the recent GDP number does not represent the pain seen in October or the pain we will see in November and December. I am not saying the markets will fall, I am saying spending will fall on a YOY basis. Although this may be painful for retailers and the economy in the near term I can think of nothing better than U.S. consumers tightening their purse strings and hopefully reducing some of that outstanding debt, not to mention I would love to get our savings rate up there, remember counting on social security to support you in your golden years is a fool hardy proposition.
One thing that is becoming starkly obvious is the stimulus package has not succeeded as many had hoped. It is slowly becoming more evident that another stimulus could possibly be needed. Another large stimulus in the range of $200bn + will be needed to offset the sharp drop in spending relative to income by US households and businesses (i.e., the increase in the private sector financial balance) that is now underway due to the tightening of financial conditions. If left unchecked, this retrenchment raises the risk of yet more adverse feedback effects between the real economy and the financial sector.
Aggressive government responses could limit the impact of the adjustment (in other words no action is clearly the wrong action) both directly via the fiscal boost and indirectly by stabilizing expectations and financial conditions. What is technically worrying about this is that the US budget deficit is already quite large and any further leveraging might damage the system (i.e. our old nemesis inflation might rear its ugly head). But taken in perspective this objection is misguided because it ignores the greater cost of letting the downturn continue unchecked. Net-net I think we will see our federal deficit continue to climb until we see substantial government action. Remember the Federal Deficit equals the sum of private sector surplus and net-foreign capital inflow. Although it is just an accounting identity, this equation has the following, very powerful implication: An increase in the private sector balance must raise the government deficit by the same dollar amount, unless it is offset by a reduction in the current account deficit. Historically higher private sector balances have been a bad thing. In principle, it would be nice to see a package that offsets the entire negative impulse to economic activity since further increases in unemployment – from a level that is already well above what’s needed to control inflation are – a pure social “bad”. In theory, one might argue that this requires an increase in government spending on domestic goods and services of 4% of GDP or a tax cut – which inevitably involves some “leakage” into increased imports – of 6% of GDP. In dollar terms, this would imply a massive $600-$900bn stimulus. Either way I would bet the next administration does something within their first month of office (that’s if something doesn’t get done sooner).
The recent weakness in emerging markets has raised concerns in developed markets about the overall impact on profits as well as the specific risks to companies with high revenue and net income exposure to EM. In general, until very recently, the highly exposed companies have outperformed the broader market and their more domestically exposed counterparts. However, the sharp reversal of performance in these stocks being seen currently reflects the growing concern about further EM activity weakness (For an illustrative example see IBM or YUM). While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.
Earlier in the year emerging markets were seen to as a pillar of stability since the credit crunch started to emerge in the summer of 2007. Three key factors were at play. Firstly, emerging market banks were seen to be relatively unaffected by the deepening crisis in the US mortgage market, secondly emerging markets were continuing to weather a slowdown in export growth as domestic demand remained robust, and thirdly most of emerging markets benefited from higher commodity prices as they were commodity producers. With the fall in commodity prices and the worsening of the global credit markets EM indexes and stocks have fallen sharply. Emerging countries typically have had limited access to USD funding in proportion to their IMF quota. The Fed, however, on October 30, 2008 announced that it is extending dollar swap lines to the central banks of Brazil, Mexico, Korea and Singapore so as to boost USD liquidity in those emerging markets. The swap lines amount to US$30 billion for each central bank. These swap arrangements allow central banks in the major countries to provide liquidity to their local banks without having to deplete reserves or tap the normal FX market. However, if central banks in the other parts of the emerging world want to provide their banks with USD without impacting the normal FX market, they have to use either their reserves, turn to the IMF or look at less orthodox measures such as capital controls. These fears have made it more difficult to roll over existing liabilities in global capital markets and even harder to issue more debt, putting pressure on countries that do not have enough liquid assets to offset the shortage in foreign liquidity. Asian countries are less exposed to this risk relative to Eastern European countries, Latin America and Asian economies that have recently come under pressure (like Indonesia and Korea) rank somewhere in the middle in terms of exposure. The growing focus on the vulnerability of Central and Eastern European economies has been reflected in weakening currencies in the region, prompting several EM central banks to tighten liquidity either by intervening in the FX markets (and reducing reserves) or through higher overnight rates (for example the National Bank of Hungary raised rates by 300 bps, while overnight rates in Romania reached a peak of 500% last week). Weakening currencies have two major impacts. First, Eastern European countries have borrowed in foreign currencies and will face higher repayments when their national currency weakens. Second, for foreign companies exposed to this region, they will have lower profits when they translate them in their reporting currency. Growth expectations for the region have come down aggressively. While Russian GDP growth accelerated to 8% in 2007-2008H1, the pace of activity had already slowed before the banking crisis hit. The slowdown started on the back of a rapidly tightening labor market and widespread price pressures. The banking crisis has significantly added to the problems. Despite significant injections of liquidity into the banking system by the Central Bank of Russia and Finance Ministry, inter-bank lending has ground to a virtual halt over recent weeks with significant negative impacts on banks funding. Working capital constraints have emerged and anecdotal evidence suggests this is causing stoppages at a number of manufacturing facilities; this will ultimately result in starkly lower productivity. On top of the risks to growth, several countries in the region have needed to turn to the IMF for financial support. While Iceland and the Ukraine have already negotiated broad packages with the IMF, Hungary reached an agreement with the IMF for a package amounting to US$25.1 billion (including €6.5 billion from the EU and €1 billion from the World Bank). Interestingly, in contrast to what we saw in the Asian crisis, the programs have less conditionality than in the past. These are likely to be supported by at least some extension of liquidity support from central banks in advanced economies through the expanded use of swap lines and similar instruments. Together these should boost investor confidence and trigger a return of capital inflows. However, the sheer size of the external funding requirements in these countries means that some may still have to experience a sharp contraction in import demand.
While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, high EM-exposed banks and telecoms have only recently started to underperform the broader market and their own sectors. In both cases, however, the recent falls seem to have overshot their peers in emerging markets. Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Amongst this group basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.
The real question in my mind is when the developed markets calm are the EMs going to be the first to “pop” back up? As the world is painfully learning, the problem with leverage is that it is much easier to create than to reign in. Banks can, in effect, create leverage out of thin air. For example, when a bank makes a loan, it creates both an asset for the borrower (the proceeds from the loan) and a liability (the obligation to repay the loan). However, if the bank wants to reduce its leverage, things are not so easy. The bank can either wait until the loan is repaid (which can take a long time) or sell the loan to a third party. And even if there is a secondary market for such a loan – and recently such markets have become increasingly illiquid – selling the loan does nothing to reduce overall leverage in the financial system. This is because of the iron law of finance: for every buyer there has to be a seller. The liquidity that the bank gets from selling the loan is offset by the liquidity lost by the party that purchases the loan. But this creates an obvious problem. If most institutions are trying to delever at the same time, then asset prices must decline until enough investors with sufficient liquidity are lured back into the market. Needless to say, this dynamic has the potential to be particularly damaging to emerging markets (as we have seen over the past few weeks). On balance, the question of whether we see another full-blown EM crisis (i.e. worse than it is today) will hinge on the speed and vigor of the policy response. Thus far, the response from policymakers has been encouraging, which suggests to us that a baseline scenario in which all but the most levered EMs face a soft-landing is still the most likely outcome. That being said I think it might be time to look into the best positioned EM. I personally am most fond of Brazil as I think they have the cleanest balance sheet and should benefit from either their strong natural resources or/and their buoyant domestic economy.
Hopefully next week I hope to present a stock idea, I know I have been saying this for some time, problem is I am finding a lot of flaws in numerous ideas so I have yet to find one that I am comfortable presenting. Rest assured I will find one, so keep reading.
Sunday, October 26, 2008
The second mouse gets the cheese....
All week I have been inundated with various people (whether colleagues or market pundits) calling for market bottoms. I have not made up my mind yet on where the bottom will be, I think the US presidential election in November will be a real catalyst but expect any real political stimulus to come in 2009. Lawmakers will make a push to enact stimulus in a post-election “lame duck” session of Congress. This is likely to mean that a proposal takes shape, at least in draft form, by the week of November 10, and comes to the floor the week of November 17. Debate would probably last the full week, and could possibly run into early December. However, there is a possibility that stimulus could be delayed until late January or February. The legislative calendar is short, and it is entirely possible that lawmakers could fail to agree on a package. It is also possible that President Bush could veto a fiscal stimulus bill. It is also possible that if Democrats make significant gains on Election Day, they will aim to pass a first round of stimulus in November, and a second round focusing on Democratic priorities early next year. It should be noted that the stock market and economy rarely (read never) bottom at the same time, so at this juncture it might be prudent to start accumulating a little here and a little there. Remember while the early gets the worm it is the second mouse that gets the cheese. One strategy that is looking increasingly profitable is to sell out of the money short term puts, this acts similarly to a limit order with the key difference being the purchase risk and premiums received associated with the puts. With the VIX at such a high level you can find some substantial yields on such a strategy.
That being said let’s take see where we stand.
For several reasons, corporate liquidity is becoming a very valuable resource. First, the primary market is likely to remain slow, as investors are still recovering from recent losses. Moreover, expect banks to continue to act conservatively when underwriting new business, despite the windfall of new capital. Second, the bleak economic outlook is likely to cut into corporate cash flow - profit expectations are already falling fast. Third, the recent injection of bank capital and debt guarantees, along with other tools, are designed to help the credit markets defrost, but the toolkit offers little direct help to non-financials. In summary, corporations could get a hit on both the earnings and the liability side.
Slowing profit growth and the negative outlook for funding are causing firms to tap their existing credit lines. According to the Wall Street Journal 18 companies have drawn down on bank lines following the Lehman default. This is partly to replace funding across the malfunctioning credit markets. For many companies, credit lines are the best option, since the long-term primary market remains fairly inaccessible because of weak investor demand. The recent large defaults will have a long lasting impact on investor’s risk aversion. The terms of the facility commitments from agreements signed in the recent boom years are likely a cheaper source of credit compared to the current market rates on bond and loan funding.
One instructive example is Goodyear Tire’s announcement on September 25th, that they were drawing $600 mm from their revolving credit line. Goodyear explained the credit line was tapped because they had $360 mm frozen in a money market fund with redemption problems. Following the news, Goodyear’s CDS spread widened 300 basis points.
Dislocations continue to cross historical highs in virtually every segment of the credit market. The current disruption of funding markets and the subsequent poor market liquidity are the main drivers of this situation. Therefore, the improvement of short-term funding conditions is a necessary condition for normalization going forward.
Defaults. This recession will be deeper and longer than we expected just a month ago (let’s just hope is a long flat U as opposed to the dreaded L). While the money market will gradually improve as systemic fears begin to relax, stabilization will be slow. The slow normalization of the money market will cause bank lending terms to crunch tighter, perhaps sharply; GDP and profit growth will slow accordingly.
Spreads. While spreads on banks and other financial institutions have substantially tightened on the back of the recent policy measures, the macro uncertainty is still high. This should start to weigh on consumer, retail and cyclical names, expect them to underperform.
The sharp underperformance of EM equities relative to developed markets, and now of EM currencies to the majors are also what you would ‘expect’ to see in a broad global slowdown. And even the dramatic dollar move is consistent with this general theme as the market has been in the process of reversing a two-year view that the US is uniquely exposed to slowing – and in unique need of easier financial conditions – and moved to price a more uniform global slowdown. The shift in pressure to emerging market FX – most recently to EMEA currencies – is also in part a reflection of the fact that the global slowdown and credit crisis has broadened to a point where even the more resilient are likely to share more pressure that until recently the market expected them to escape. The acceleration in many of these moves is consistent not just with increased funding and financial market stress but with the data.
That being said let me venture a wild guess about the future. Deleveraging is going to be a long and painful process. The economy will not likely turn until either housing stops declining or banks start lending. Sadly I think both are likely to occur at the same time. As the banking system gets more aid bankers will start lending albeit and much higher rates. These higher rates will spur a lack of consumer spending which will bring prices down. This deflationary spiral will be countered by the new president and his various “stimulus packages.” It is my opinion that the government is terrible at market timing and as such will continue their inflationary inducing policies long after the deflationary threat has faded away. This couple with massive US debt spells a long-term weakening dollar versus export driven economies. We have already seen the Yen appreciate massively against the dollar and I expect to see the Brazilian Real, Reminbi, and the Rouble (so long as the Russian government doesn’t screw things up). I think we will see hardline retailers continued to be punished by reduced consumer spending but I think softline retailers like Wal-Mart, Target, and Costco could offer an interesting entry point should the equities fall further. I think the decline in oil will likely overshoot to the downside and should offer interesting opportunities to the savvy investor. I would particularly look towards MLPs and E&Ps offering high yields with clean balance sheets. Lately I have been thinking about how the economy moves in cycles. For example, the following I would classify as periods of consumer leveraging their balance sheets (1920s, 1960s & early 1970s, 1980s, and obviously the 2000s). Each of these periods were marked by massive run ups in equities followed by severe declines. What led to the next run up is of interest to me. The Great Depression was ended by World War II so I hope we can avoid that alternative. The 1970s was turned around by a massive drop in commodities and raising rates to the point of reducing inflation (this is possible although I would be shocked to see commodities fall to that point). The bear market of 1991-1993 was ended by the mass proliferation of the computer and the internet. So this brings us to now, I can’t help but wonder what innovation our policy will lead us out of this recession. As previously stated I think we will likely see some inflationary policies put in place by the new administration and this will revive the system but not stimulate significant growth without substantially deflating the dollar. Being an eternal optimist I am hopeful that someone will crack the energy mystery (maybe the University of Utah can rediscover how they cracked cold fusion). Either way I expect this to be three to four year period of slow to no growth. That being said I urge people to consider putting their money in companies with sterling balance sheets and enormously wide economic moats. I expect to post an example of such a situation over the next week or two. If you have any suggestions or ideas of your own please feel free to post them.
Also on another side note if you I strongly suggest people to look into various special situations. For example watch Volkswagen to see if it rallies in another short squeeze if it does, short it. VW was trading in the 80s during last week which is a PE of 33 times 2009 earnings which is five times the industry level (mind you the industry is likely to decline as consumers are less likely to purchase a car over the next year). Over the past year VW’s shares are up over 100%, this is due to the concentrated ownership and massive amounts of hedge funds who were short the stock and had to cover at the same time when there was an extremely limited float (especially with the bankruptcy of Lehman who was one of the largest lenders in the stock). On a fundamental basis VW is worth around $30 (it closed on Friday at 53 which is down from 90 the week before). I expect to continue to see this company to fall as hedge funds are no longer being squeezed (at least for now) and investors realize the terrible underlying fundamentals of the auto business. It is temporary mispricing situations like these that are going to offer the majority of profits over the next couple months. Keep an eye out for these, especially in the small cap and micro cap space as this is where they are more likely to exist.
That being said let’s take see where we stand.
For several reasons, corporate liquidity is becoming a very valuable resource. First, the primary market is likely to remain slow, as investors are still recovering from recent losses. Moreover, expect banks to continue to act conservatively when underwriting new business, despite the windfall of new capital. Second, the bleak economic outlook is likely to cut into corporate cash flow - profit expectations are already falling fast. Third, the recent injection of bank capital and debt guarantees, along with other tools, are designed to help the credit markets defrost, but the toolkit offers little direct help to non-financials. In summary, corporations could get a hit on both the earnings and the liability side.
Slowing profit growth and the negative outlook for funding are causing firms to tap their existing credit lines. According to the Wall Street Journal 18 companies have drawn down on bank lines following the Lehman default. This is partly to replace funding across the malfunctioning credit markets. For many companies, credit lines are the best option, since the long-term primary market remains fairly inaccessible because of weak investor demand. The recent large defaults will have a long lasting impact on investor’s risk aversion. The terms of the facility commitments from agreements signed in the recent boom years are likely a cheaper source of credit compared to the current market rates on bond and loan funding.
One instructive example is Goodyear Tire’s announcement on September 25th, that they were drawing $600 mm from their revolving credit line. Goodyear explained the credit line was tapped because they had $360 mm frozen in a money market fund with redemption problems. Following the news, Goodyear’s CDS spread widened 300 basis points.
Dislocations continue to cross historical highs in virtually every segment of the credit market. The current disruption of funding markets and the subsequent poor market liquidity are the main drivers of this situation. Therefore, the improvement of short-term funding conditions is a necessary condition for normalization going forward.
Defaults. This recession will be deeper and longer than we expected just a month ago (let’s just hope is a long flat U as opposed to the dreaded L). While the money market will gradually improve as systemic fears begin to relax, stabilization will be slow. The slow normalization of the money market will cause bank lending terms to crunch tighter, perhaps sharply; GDP and profit growth will slow accordingly.
Spreads. While spreads on banks and other financial institutions have substantially tightened on the back of the recent policy measures, the macro uncertainty is still high. This should start to weigh on consumer, retail and cyclical names, expect them to underperform.
The sharp underperformance of EM equities relative to developed markets, and now of EM currencies to the majors are also what you would ‘expect’ to see in a broad global slowdown. And even the dramatic dollar move is consistent with this general theme as the market has been in the process of reversing a two-year view that the US is uniquely exposed to slowing – and in unique need of easier financial conditions – and moved to price a more uniform global slowdown. The shift in pressure to emerging market FX – most recently to EMEA currencies – is also in part a reflection of the fact that the global slowdown and credit crisis has broadened to a point where even the more resilient are likely to share more pressure that until recently the market expected them to escape. The acceleration in many of these moves is consistent not just with increased funding and financial market stress but with the data.
That being said let me venture a wild guess about the future. Deleveraging is going to be a long and painful process. The economy will not likely turn until either housing stops declining or banks start lending. Sadly I think both are likely to occur at the same time. As the banking system gets more aid bankers will start lending albeit and much higher rates. These higher rates will spur a lack of consumer spending which will bring prices down. This deflationary spiral will be countered by the new president and his various “stimulus packages.” It is my opinion that the government is terrible at market timing and as such will continue their inflationary inducing policies long after the deflationary threat has faded away. This couple with massive US debt spells a long-term weakening dollar versus export driven economies. We have already seen the Yen appreciate massively against the dollar and I expect to see the Brazilian Real, Reminbi, and the Rouble (so long as the Russian government doesn’t screw things up). I think we will see hardline retailers continued to be punished by reduced consumer spending but I think softline retailers like Wal-Mart, Target, and Costco could offer an interesting entry point should the equities fall further. I think the decline in oil will likely overshoot to the downside and should offer interesting opportunities to the savvy investor. I would particularly look towards MLPs and E&Ps offering high yields with clean balance sheets. Lately I have been thinking about how the economy moves in cycles. For example, the following I would classify as periods of consumer leveraging their balance sheets (1920s, 1960s & early 1970s, 1980s, and obviously the 2000s). Each of these periods were marked by massive run ups in equities followed by severe declines. What led to the next run up is of interest to me. The Great Depression was ended by World War II so I hope we can avoid that alternative. The 1970s was turned around by a massive drop in commodities and raising rates to the point of reducing inflation (this is possible although I would be shocked to see commodities fall to that point). The bear market of 1991-1993 was ended by the mass proliferation of the computer and the internet. So this brings us to now, I can’t help but wonder what innovation our policy will lead us out of this recession. As previously stated I think we will likely see some inflationary policies put in place by the new administration and this will revive the system but not stimulate significant growth without substantially deflating the dollar. Being an eternal optimist I am hopeful that someone will crack the energy mystery (maybe the University of Utah can rediscover how they cracked cold fusion). Either way I expect this to be three to four year period of slow to no growth. That being said I urge people to consider putting their money in companies with sterling balance sheets and enormously wide economic moats. I expect to post an example of such a situation over the next week or two. If you have any suggestions or ideas of your own please feel free to post them.
Also on another side note if you I strongly suggest people to look into various special situations. For example watch Volkswagen to see if it rallies in another short squeeze if it does, short it. VW was trading in the 80s during last week which is a PE of 33 times 2009 earnings which is five times the industry level (mind you the industry is likely to decline as consumers are less likely to purchase a car over the next year). Over the past year VW’s shares are up over 100%, this is due to the concentrated ownership and massive amounts of hedge funds who were short the stock and had to cover at the same time when there was an extremely limited float (especially with the bankruptcy of Lehman who was one of the largest lenders in the stock). On a fundamental basis VW is worth around $30 (it closed on Friday at 53 which is down from 90 the week before). I expect to continue to see this company to fall as hedge funds are no longer being squeezed (at least for now) and investors realize the terrible underlying fundamentals of the auto business. It is temporary mispricing situations like these that are going to offer the majority of profits over the next couple months. Keep an eye out for these, especially in the small cap and micro cap space as this is where they are more likely to exist.
Sunday, October 19, 2008
This will have to do....
I was going to write something over the weekend, but I had to work on both Saturday and Sunday so this will have to do.
Sunday, October 12, 2008
Mr. Toad's Wild Ride
It goes without saying that this past week is not one that will be soon forgotten. In light of the recent coordinated government interventions, I would expect money markets to start behaving more normally, and ever so slowly as risk aversions start to fade we will start to see an increased interest in corporate in bank debt which should assuage the equity market’s fears and allow them to become more calmed. This is not to say I am calling a bottom, I am just pointing out that the recent high volatility (highest recorded level on the VIX, although technically the VIX would have been higher during 1987 (somewhere around 150 vs. 70 or so now, it just wasn’t around then) can be expected to dissipate at as people become more risk tolerant.
Speaking of bottoms, I just wanted to make a quick note on where and how I think we can bottom. In order for the markets to bottom, house prices will have to stop their decline. Now many people are predicting a price bottoming in the first quarter or second quarter of 2009 which is when many sub-prime resets will taper off. Although this is somewhat logical they are ignoring the wave of Option ARMSs and Alt-A which reset in 2010 and 2011. These will cause significant pain should their reset be anything like the one we went through with sub-prime resets.
Before we get into the meat of this week’s post I just want to take a minute to say, those who took my advice and went short on ZOLT, it is probably now time to close that trade, since recommending the short on Sept. 7th the stock has fallen from $17.21 (Friday Sept. 5th close) to $10.00 (Friday Oct. 10th close) which represents a nice 42% profit in the span of about a month.
The turmoil in global financial markets has recently put pressure on nearly all emerging markets (EM) assets. In part, the move has been driven by concerns for the global slowdown and its possible impact on EM. On the other hand, economies like Brazil and Malaysia appear better shielded growth-wise when looking at typical macroeconomic shocks. Over the last month, however, the forces of financial deleveraging, risk aversion and positioning liquidation have taken center stage in driving asset prices. This has raised concerns among investors about the vulnerability of different emerging markets to broader strains in the financial sector and global markets.
The good news for EM is that there is no strong evidence that they are caught overly levered in the middle of this deleveraging process. EM fundamentals have improved substantially over the last few years and are still supportive in terms of economic stability and growth, overall. In fact, the current turmoil is much different than previous episodes of distress for EM assets; it is not an EM crisis, it is financial volatility imported from a shock that originated in G10 economies. However, the recent underperformance in EM currencies with stronger fundamentals stands as a reminder that financial turbulence can affect local assets in many ways, and not necessarily in connection with the economic performance of the country. There are different notions of exposure to financial volatility. Local assets can come under pressure through various channels; a disruption in international capital flow, a reversal of capital flows accumulated in the past, a strain in the financing of short-term external liabilities or some genuine fragility of the local financial system. On average, emerging markets appear to be more resilient than major markets on most indicators (exhibiting more resilience to shorter-term capital flows disruptions, short-term financing dislocations and soundness of the banking system).
Given the recent government moves what does this all mean in the FX space? The US trade balance will likely improve further. While exports will probably slow on the back of slowing global demand, US imports may slow even more on the back of extremely tight financial conditions and expectations of a recession.
Despite the US trade balance improvement, funding inflows into the US are likely to slow as well, given the weak cyclical outlook. Moreover, the Dollar is clearly less undervalued at current levels and further appreciation would probably make life more difficult for the export sector and hence not help the weak US economy. Therefore, after a stabilization of asset markets, we are likely to see first a period of renewed moderate Dollar weakness, before the longer-term appreciation trend towards fair value kicks in.
Slowing global growth will continue to put downside pressure on currencies that display a strong link to cyclical forces, such as the AUD. However, some of these currencies have depreciated rapidly in recent weeks and this may limit the additional depreciation risks.
Moreover, lower oil prices and substantial policy stimulus mean that growth rebounds are possible in the not too distant future, led by strong structural stories, such as the BRICs and N-11. Rate differentials are also likely to play in favor of EM currencies, in particular following the rapid decline of policy rates in major markets.
So net-net, I think given the sharp pull back it might be time to purchase some EM equities or balanced ETFs. Sorry for the brief post, but I have been at work all weekend and still have another two hours plus of stuff to get done.
Speaking of bottoms, I just wanted to make a quick note on where and how I think we can bottom. In order for the markets to bottom, house prices will have to stop their decline. Now many people are predicting a price bottoming in the first quarter or second quarter of 2009 which is when many sub-prime resets will taper off. Although this is somewhat logical they are ignoring the wave of Option ARMSs and Alt-A which reset in 2010 and 2011. These will cause significant pain should their reset be anything like the one we went through with sub-prime resets.
Before we get into the meat of this week’s post I just want to take a minute to say, those who took my advice and went short on ZOLT, it is probably now time to close that trade, since recommending the short on Sept. 7th the stock has fallen from $17.21 (Friday Sept. 5th close) to $10.00 (Friday Oct. 10th close) which represents a nice 42% profit in the span of about a month.
The turmoil in global financial markets has recently put pressure on nearly all emerging markets (EM) assets. In part, the move has been driven by concerns for the global slowdown and its possible impact on EM. On the other hand, economies like Brazil and Malaysia appear better shielded growth-wise when looking at typical macroeconomic shocks. Over the last month, however, the forces of financial deleveraging, risk aversion and positioning liquidation have taken center stage in driving asset prices. This has raised concerns among investors about the vulnerability of different emerging markets to broader strains in the financial sector and global markets.
The good news for EM is that there is no strong evidence that they are caught overly levered in the middle of this deleveraging process. EM fundamentals have improved substantially over the last few years and are still supportive in terms of economic stability and growth, overall. In fact, the current turmoil is much different than previous episodes of distress for EM assets; it is not an EM crisis, it is financial volatility imported from a shock that originated in G10 economies. However, the recent underperformance in EM currencies with stronger fundamentals stands as a reminder that financial turbulence can affect local assets in many ways, and not necessarily in connection with the economic performance of the country. There are different notions of exposure to financial volatility. Local assets can come under pressure through various channels; a disruption in international capital flow, a reversal of capital flows accumulated in the past, a strain in the financing of short-term external liabilities or some genuine fragility of the local financial system. On average, emerging markets appear to be more resilient than major markets on most indicators (exhibiting more resilience to shorter-term capital flows disruptions, short-term financing dislocations and soundness of the banking system).
Given the recent government moves what does this all mean in the FX space? The US trade balance will likely improve further. While exports will probably slow on the back of slowing global demand, US imports may slow even more on the back of extremely tight financial conditions and expectations of a recession.
Despite the US trade balance improvement, funding inflows into the US are likely to slow as well, given the weak cyclical outlook. Moreover, the Dollar is clearly less undervalued at current levels and further appreciation would probably make life more difficult for the export sector and hence not help the weak US economy. Therefore, after a stabilization of asset markets, we are likely to see first a period of renewed moderate Dollar weakness, before the longer-term appreciation trend towards fair value kicks in.
Slowing global growth will continue to put downside pressure on currencies that display a strong link to cyclical forces, such as the AUD. However, some of these currencies have depreciated rapidly in recent weeks and this may limit the additional depreciation risks.
Moreover, lower oil prices and substantial policy stimulus mean that growth rebounds are possible in the not too distant future, led by strong structural stories, such as the BRICs and N-11. Rate differentials are also likely to play in favor of EM currencies, in particular following the rapid decline of policy rates in major markets.
So net-net, I think given the sharp pull back it might be time to purchase some EM equities or balanced ETFs. Sorry for the brief post, but I have been at work all weekend and still have another two hours plus of stuff to get done.
Sunday, October 5, 2008
Black murky waters...
In this past week the overall feeling in the market has shown a sudden and abrupt volte-face and it finally appears that the market and investing community has realized that regardless of the “bail-out” the economy is still going through tough times and is unlikely to reverse direction any time in the near future. Internally I am torn about this sudden widespread realization. On the one hand the value investor in me is in fine fettle, on the other hand the altruistic global citizen in me is nervous about our near to medium term prospects (hence the title of the post). That being said there is always a way to profit in any market so let’s try to find out how.
The passage of the TARP plan will increase our federal deficit substantially. The current fiscal year 2009 deficit (which is the current FY) is estimated to be at $565bn and this was before the passage of the TARP. If you take this plus the estimated cost of TARP plus additional maturing coupons our federal deficit could reach a staggering $1.5 trillion (with a T!). With all this additional debt you have to wonder how our dollar is strengthening versus other currencies. The key to this is it is all relative. The EU and UK were viewed as relatively strong and as such had strengthened substantially against the dollar over the past couple of years. Now that everyone realizes that they are not immune from the financial malaise, their currencies have been dropping precipitously. This in turn has been quite negative for export heavy companies. While I believe we will continue to strengthen against the EUR, GBP, NZD, AUD, and YEN, I believe we will start to weaken against EM currencies which are heavy on natural resource exportation. This is the perfect segway in to what is turning out to be my weekly update on the energy markets.
Over the past several weeks, the oil market has been whipsawed between two opposing forces: (1) strong near-term fundamentals driven by continued supply problems and extremely low inventories; and (2) rising financial and forward demand concerns which have been accompanied by significant financial de-leveraging. As the market continues to be pulled in both directions by these opposing forces, price volatility has surged. This surge in price volatility represents a significant departure from the past five years, as the one variable in the market that remained relatively stable was volatility, trading in roughly a 30-40% range. The market simply trended up or down and inventories in the United States and the rest of the OECD remained above or near the five-year average, providing a cushion to any supply or demand disruption. However, beginning this summer and accelerating this past week that trend has been clearly reversed – implied volatility reached 55% this past week as inventories continued to plummet due to hurricane-related disruptions. Volatility has not been this high, nor have stocks been this low on a seasonally adjusted basis since the Gulf War II in 2003 (see below):
US inventories dropped a massive 18 million barrels, bringing the total inventory draw since August 28, 2008 to 50 million barrels. US total hydrocarbon stocks are now at record low levels for this time of year, and US gasoline inventories are now at levels not seen since 1967 when demand was nearly half the level as it is today. Further, the situation for gasoline on the other side of the Atlantic is no better, with Europe also at low inventory levels with ARA stocks dropping to the lowest levels since 2003. Further, this week saw crude oil stock draws in Japan that took stock levels back to record lows for this time of year. What is critical is that this is the period in which stocks should be built globally to prepare for the winter months, not drawn. This puts the market into a very precarious situation as we near the winter heating season. Many observers point to the fact that demand is weak, so this observation is not as worrying as it would otherwise be. In fact, the US Department of Energy (DOE) reported exceptionally weak product demand last week. Although this demand weakness generated downward price pressure post the data release, it is again important to emphasize that you can’t consume what you don’t have. Ongoing refinery outages have left US refinery utilization at critically low levels leading to a loss so far of almost 70 million barrels of petroleum products. As a result of the outages, Colonial Pipeline – the primary artery for USGC petroleum product distribution in the southern and eastern United States – has been operating at reduced rates, generating local shortages and reports of long lines at the pump (hence the news of gasoline shortages in the south). It is important to highlight that despite this extreme tightness in gasoline supplies, traded NYMEX gasoline margins have weakened substantially in the past two weeks.
Over the past several weeks, concerns over the sustainability of Chinese oil demand have been brought into question. Driving these concerns have been real events. Two weeks ago Sinopec announced it would reduce fourth-quarter crude oil imports by 8-10 percent from previous targets as end-use inventories inside China remain high. And then last week, Unipec announced it would not import diesel for a third straight month again due to high domestic inventory levels. At the same time, expectations for 2009 Chinese growth have been revised down.
First, in terms of the base levels, these slower growth expectations do not have a large impact in terms of barrels. At most it would slow end-use oil demand growth by 70 thousand b/d and in terms of crude oil imports for the fourth quarter relative to previously announced targets, and would slow imports from 14% yoy growth to 9% yoy growth, which is still relatively strong growth from a historical perspective.
Second, the Chinese government still has two very significant policy levers at its disposal, both fiscal and monetary policy. On the fiscal side, unlike previous time periods of slower growth, the Chinese government has at its disposal 2-3% of GDP for fiscal stimulus. On the monetary side, we saw the central bank aggressively raise rates to counter inflationary pressures. Now that those inflationary pressures, particularly from agriculture, have abated, they are likely to be equally aggressive in lowering rates. The bottom line is that the government is likely to act with policy in response to the current concerns, which will likely avert a more serious slowdown. This aversion should help keep their demand high which helps add to the bullish oil argument.
In the near future I will make a specific company recommendation, so until then keep reading.
The passage of the TARP plan will increase our federal deficit substantially. The current fiscal year 2009 deficit (which is the current FY) is estimated to be at $565bn and this was before the passage of the TARP. If you take this plus the estimated cost of TARP plus additional maturing coupons our federal deficit could reach a staggering $1.5 trillion (with a T!). With all this additional debt you have to wonder how our dollar is strengthening versus other currencies. The key to this is it is all relative. The EU and UK were viewed as relatively strong and as such had strengthened substantially against the dollar over the past couple of years. Now that everyone realizes that they are not immune from the financial malaise, their currencies have been dropping precipitously. This in turn has been quite negative for export heavy companies. While I believe we will continue to strengthen against the EUR, GBP, NZD, AUD, and YEN, I believe we will start to weaken against EM currencies which are heavy on natural resource exportation. This is the perfect segway in to what is turning out to be my weekly update on the energy markets.
Over the past several weeks, the oil market has been whipsawed between two opposing forces: (1) strong near-term fundamentals driven by continued supply problems and extremely low inventories; and (2) rising financial and forward demand concerns which have been accompanied by significant financial de-leveraging. As the market continues to be pulled in both directions by these opposing forces, price volatility has surged. This surge in price volatility represents a significant departure from the past five years, as the one variable in the market that remained relatively stable was volatility, trading in roughly a 30-40% range. The market simply trended up or down and inventories in the United States and the rest of the OECD remained above or near the five-year average, providing a cushion to any supply or demand disruption. However, beginning this summer and accelerating this past week that trend has been clearly reversed – implied volatility reached 55% this past week as inventories continued to plummet due to hurricane-related disruptions. Volatility has not been this high, nor have stocks been this low on a seasonally adjusted basis since the Gulf War II in 2003 (see below):
US inventories dropped a massive 18 million barrels, bringing the total inventory draw since August 28, 2008 to 50 million barrels. US total hydrocarbon stocks are now at record low levels for this time of year, and US gasoline inventories are now at levels not seen since 1967 when demand was nearly half the level as it is today. Further, the situation for gasoline on the other side of the Atlantic is no better, with Europe also at low inventory levels with ARA stocks dropping to the lowest levels since 2003. Further, this week saw crude oil stock draws in Japan that took stock levels back to record lows for this time of year. What is critical is that this is the period in which stocks should be built globally to prepare for the winter months, not drawn. This puts the market into a very precarious situation as we near the winter heating season. Many observers point to the fact that demand is weak, so this observation is not as worrying as it would otherwise be. In fact, the US Department of Energy (DOE) reported exceptionally weak product demand last week. Although this demand weakness generated downward price pressure post the data release, it is again important to emphasize that you can’t consume what you don’t have. Ongoing refinery outages have left US refinery utilization at critically low levels leading to a loss so far of almost 70 million barrels of petroleum products. As a result of the outages, Colonial Pipeline – the primary artery for USGC petroleum product distribution in the southern and eastern United States – has been operating at reduced rates, generating local shortages and reports of long lines at the pump (hence the news of gasoline shortages in the south). It is important to highlight that despite this extreme tightness in gasoline supplies, traded NYMEX gasoline margins have weakened substantially in the past two weeks.
Over the past several weeks, concerns over the sustainability of Chinese oil demand have been brought into question. Driving these concerns have been real events. Two weeks ago Sinopec announced it would reduce fourth-quarter crude oil imports by 8-10 percent from previous targets as end-use inventories inside China remain high. And then last week, Unipec announced it would not import diesel for a third straight month again due to high domestic inventory levels. At the same time, expectations for 2009 Chinese growth have been revised down.
First, in terms of the base levels, these slower growth expectations do not have a large impact in terms of barrels. At most it would slow end-use oil demand growth by 70 thousand b/d and in terms of crude oil imports for the fourth quarter relative to previously announced targets, and would slow imports from 14% yoy growth to 9% yoy growth, which is still relatively strong growth from a historical perspective.
Second, the Chinese government still has two very significant policy levers at its disposal, both fiscal and monetary policy. On the fiscal side, unlike previous time periods of slower growth, the Chinese government has at its disposal 2-3% of GDP for fiscal stimulus. On the monetary side, we saw the central bank aggressively raise rates to counter inflationary pressures. Now that those inflationary pressures, particularly from agriculture, have abated, they are likely to be equally aggressive in lowering rates. The bottom line is that the government is likely to act with policy in response to the current concerns, which will likely avert a more serious slowdown. This aversion should help keep their demand high which helps add to the bullish oil argument.
In the near future I will make a specific company recommendation, so until then keep reading.
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