Tag: finance

Submitted by Michael Every of Rabobank

Awe & Shock; Questions & Quislings

Last week was about policy-makers keeping us in awe. Central banks have done what central banks do – slash rates and pump in liquidity (the latest being the Bank of Canada taking rates to 0.25%, joining the zero-lower-bound-and-let’s-do-QE gang). Governments have done what they had long decided not to do – ramp up spending and pump in liquidity (the latest being Australia now offering to pay 80% of salaries for those laid off too). None of this should be a surprise. As we published recently, and as many others in the market are echoing, this is being treated as a war on the home front: and wars on the home front mean zero rates, yield curve control, and fiscal deficits from 15 to 20% of GDP. Markets have, of course, tried to rally on that front. It’s even been seen as patriotic in some cases.

However, here comes the shock that has required all that awe. Last week US President Trump was talking about reopening the economy around Easter: now lockdown is extended through to 30 April. Moreover, Dr Fauci, the leading medical expert on the White House team, has stated he expects to see millions of infections and 100,000 – 200,000 US deaths. Even Trump has said 100,000 deaths would be a “very good job”. To put that in context, were we to exceed that total by just a little it would mean more civilian deaths than the US suffered in combat in WW1, Vietnam, and Korea combined. In other words, a major shock.

In the UK, the Deputy Chief Medical Officer briefed that the current lockdown could be extended for six months, and perhaps even longer – and at the minimum Britain seems to face three months under the present new normal. Much of 2020 is going to be under virus controls of some kind. Again, a major economic shock.

In China, which has apparently turned the corner vis-à-vis the virus, we have the Western media openly questioning the official figures for deaths in Wuhan; stories underlining that while people are getting back to work, exporters have nobody to produce for; a wave of consumer debt defaults seems inevitable; and, in a don’t-listen-to-what-they-say-but-watch-what-they-do way, Beijing ordered all of the country’s cinemas closed again just days after reopening them to great fanfare. Looks like a major after-shock – and in response China is already talking about more awesome fiscal stimulus in response. Let’s see how that is compatible with economic rebalancing, deleveraging, and balance of payments and currency stability.

So to Questions & Quislings (which, in a lighter moment in these dark times, sounds like an unpopular niche 1970’s role-playing game.)

Question: How bad is this going to get economically? Worse than central bank and government largesse can overcome? Is it now insolvency not illiquidity we risk? After all, US Q2 GDP is openly being discussed as falling as much as -50% q/q annualised by ne ex-Fed official; UK Q2 GDP is seen -15% y/y by the Centre for Economics and Business Research; and nobody else is looking much better.

Question: so what do we do about it? Which leads us to Quislings.

To try to relax this weekend I made the decision to listen to UK talk radio for a ‘taste of home’. One particular host was insistent that the economic shock we are experiencing was so severe that a cost-benefit analysis needed to be done immediately – and a return to work was almost certainly the best overall outcome in his mind even if he would not say so directly. In support of his position, he interviewed Professor Philip Thomas from Bristol University, whose work involves the kind of grim trade-offs highlighted in ‘Fight Club’, where car firms look at the cost of improving vehicle passenger safety features over paying out insurance claims to those who are injured or die. Thomas argued that the virus, if unchecked, might kill over a million people in the UK, and 400,000 in middle age. This was economically unacceptable, of course. However, based on his modelling (in turn based on a simple regression analysis of GDP per capita and life expectancy), if UK GDP were to fall more than 6.4% y/y then the country would see more deaths due to poverty and depression than the virus would imply, and so it would arguably be better off opening up its economy again regardless of the virus.

A philosopher(!) immediately called in to respond and pointed out what I did in an email they didn’t opt to rad: that this is an entirely false exercise in that is assumes: (1) the virus would not destroy the economy anyway even if no lockdown were in place (i.e., voluntary lockdowns); and (2) that the government cannot shift economic policy to mitigate the decline in GDP per capita under lockdown. To which the host seemed outraged: “So we have to rip up the economics textbooks?! Really?!”

Then an experienced ex-Bank of England economist called in. He supported the philosopher’s stance, and noted that the paper from Thomas had not been peer reviewed and was published in a minor non-economics journal. In his view, it belonged in the wastepaper basket. The host’s response, in so many words: “You are being too emotional saying that. Bye!”

So what’s the takeaway, apart from the obvious fact that intellectuals can be idiots and I was one for listening to talk radio? That policy awe is behind us while sheer economic shock is about to overwhelm markets ahead; and we will require even greater policy responses.

Markets are far less likely to enjoy them, however. Wars aren’t just about pump-priming. We also see regulation and excess profit taxes rather than headlines lionizing hedge funds for making USD2.6bn in profits. (That said, some of the people running this war seem like the kind of blokes who in WW2 always had black-market chocolate and nylons for sale…)

Yet for now markets need to grapple with what is going to be cheap and what is going to be expensive. Do we face deflation as the economy implodes? Oil sub USD20 per barrel says yes. Do we face inflation as supply shocks hit home? Stories suggesting countries are hoarding food and that food production could be hit by the virus also say yes.

And, looking ahead to when we win the war, which we will one day, what does the economic and financial world look like when debt to GDP will be 20-30ppts higher at least, behaviour will have changed, SMEs may have been savaged, globalisation undermined, and the government will have many large fingers in many pies? Which asset class, if any, looks a winner on that basis? Short of USD, answers are short on the ground.

So time for a quick game of Questions & Quislings!

There’s another ‘epidemic’ ripping through America that, for many on Wall Street, is just as terrifying as COVID-19… and this time The Fed is to blame.

We reported last week on the multitude of mortgage companies that were facing an existential threat from massive margin calls:

First, its was AG Mortgage Investment Trust which on Friday said it failed to meet some margin calls and doesn’t expect to be able to meet future margin calls with its current financing. Then it was TPG RE Finance Trust which also hit a liquidity wall and could not repay its lenders. Then, on Monday it was first Invesco, then ED&F Man Capital, and  now the mortgage mayhem that erupted as a daisy-chain of mortgage REITs suddenly imploded, has taken down MFA Financial, whose crashing stock was halted after the company reported that “due to the turmoil in the financial markets resulting from the global pandemic of the COVID-19 virus, the Company and its subsidiaries have received an unusually high number of margin calls from financing counterparties, and have also experienced higher funding costs in respect of its repurchase agreements.”

All of which means – in no surprise whatsoever – that these mortgage-related firms are demanding a bailout!! Because ‘Murica… and capitalism, right?

And most ironically, mortgage bankers are demanding The Fed STOP buying mortgage bonds. As Bloomberg reports, bankers are sounding alarms that The Fed’s unprecedented buying of $183 billion of bonds tied to home loans last week are unintentionally putting their industry at risk by triggering a flood of margin calls on hedges lenders have entered into to protect themselves from losses.

In a Sunday letter, the Mortgage Bankers Association (MBA) urged the U.S. Securities and Exchange Commission (SEC) and the nation’s main brokerage regulator to address the problem by telling securities firms not to escalate margin calls to “destabilizing levels.”

The MBA letter, signed by CEO Robert Broeksmit, said that when lenders issue new loans, they often simultaneously short mortgage-backed securities. This is done because the loans might fall in value before a banker can sell them to Fannie Mae and Freddie Mac. The bet against mortgage bonds helps protect the lender if that happens, Broeksmit wrote.

 “The dramatic price volatility in the market for agency mortgage-backed securities [MBS] over the past week is leading to broker-dealer margin calls on mortgage lenders’ hedge positions that are unsustainable for many such lenders.”

Now, with lenders getting crushed on these hedges, they’re facing a wave of demands from brokers that they sell holdings or put more money in their trading accounts.

“Broker-dealers’ margin calls on mortgage lenders reached staggering and unprecedented levels by the end of the past week,” Broeksmit wrote.

“The inability of a large set of responsibly-managed lenders to meet these margin calls would jeopardize the very objective of the Federal Reserve’s agency MBS purchases – the smooth functioning of both the primary and secondary mortgage markets.”

Some lenders, the letter exclaimed, may not be able to meet their margin calls in a day or two, and Barry Habib, founder of MBS Highway, a leading industry advisor who was among the first to publicly sound the alarm bell last week, warned ominously:

“This is a collapse of the system… It’s as simple as the Fed stops buying for a period of time.”

The MBA, whose members underpin the housing market, asked the watchdogs to issue guidance directing brokers to work constructively with lenders.

Additionally, as Bloomberg notes, the surge in margin calls is also inflicting major pain on commercial real estate with the threat of widespread loan defaults prompting a wave of selling of commercial mortgage-backed securities. Colony Capital’s CEO Tom Barrack reiterated his desperate pleas for a bailout on Sunday calling for a moratorium on margin calls and Fed buying to halt the sell-off for bonds tied to commercial properties.

So – to sum up the America we live in:

• MBS – Residential mortgage lenders have been crushed from hedging-implosions thanks to massive, unprecedented Fed buying in their market… and are demanding The Fed stop buying and offer them a bailout.

• CMBS/ABS – mREITs and funds have been crushed by a liquidity squeeze on their over-levered, borrow-short-lend-long-get-rich-quick plan (supported by endless Fed liquidity and rates suppression)… and are now demanding The Fed buy even more, lift accounting rules, and vanquish all margin calls.

Moral hazard and unintended consequences are everywhere as America’s elite refuse to let this crisis go to waste.

WTI prices are back above $20.00 (barely) but remain notably down on the day after reports that Presidents Trump and Putin spoke on the phone today – with the Kremlin making clear that the call was at the request of the US president.

Per the Kremlin, the heads of state “expressed serious concern over the scale of the spread of coronavirus in the world and informed each other about measures taken in Russia and the United States to counter this threat. The possibilities of closer interaction between the two countries in this direction were discussed.”

The two leaders reportedly agreed to continue personal contacts (which we are sure will trigger the liberal media) and to work towards closer COVID-19 response coordination.

Additionally, the two “exchanged views on the current state of the world oil market” and agreed on further Russian-American consultations on this subject at the ministerial level.

Finally, several other “bilateral issues” were also discussed.

How long before a transcript of the call is ‘demanded’ by Nadler and Schiff, we wonder?

Markets did not react much to the news which follows Trump’s earlier comments that Saudi Arabia and Russia “both went crazy” in their oil-price war.

Additionally, Trump said in an interview with Fox News Channel before the call with Putin:

“I never thought I’d be saying that maybe we have to have an oil (price) increase, because we do… The price is so low now they’re fighting like crazy over, over distribution and over how many barrels to let go.”

Though pump prices have yet to see the benefits…

 

 

Authored by Lance Roberts via RealInvestmentAdvice.com,

In early 2017, I warned investors about the “I bought it for the dividend” investment thesis. To wit:

“Company ABC is priced at $20/share and pays $1/share in a dividend each year. The dividend yield is 5%, which is calculated by dividing the $1 cash dividend into the price of the underlying stock.

Here is the important point. You do NOT receive a ‘yield.’

What you DO receive is the $1/share in cash paid out each year.

Yield is simply a mathematical calculation.“

At that time, the article was scoffed at because we were 8-years into an unrelenting bull market where even the most stupid of investments made money.

Unfortunately, the “mean reversion” process has taken hold, which is the point where the investment thesis falls apart.

The Dangers Of “I Bought It For The Dividend”

“I don’t care about the price, I bought it for the yield.”

First of all, let’s clear up something.

In January of 2018, Exxon Mobil, for example, was slated to pay an out an annual dividend of $3.23, and was priced at roughly $80/share setting the yield at 4.03%. With the 10-year Treasury trading at 2.89%, the higher yield was certainly attractive.

Assuming an individual bought 100 shares at $80 in 2018, “income” of $323 annually would be generated.

Not too shabby.

Fast forward to today with Exxon Mobil trading at roughly $40/share with a current dividend of $3.48/share.

Investment Return (-$4000.00 ) + Dividends of $323 (Yr 1) and $343 (Yr 2)  = Net Loss of $3334

That’s not a good investment.

In just a moment, we will come and revisit this example with a better process.

There is another risk, which occurs during “mean reverting” events, that can leave investors stranded, and financially ruined.

Dividend Loss

When things “go wrong,” as they inevitably do, the “dividend” can, and often does, go away.

• Boeing (BA)

• Marriott (MAR)

• Ford (F)

• Delta (DAL)

• Freeport-McMoRan (FCX)

• Darden (DRI)

These companies, and many others, have all recently cut their dividends after a sharp fall in their stock prices.

I previously posted an article discussing the “Fatal Flaws In Your Financial Plan” which, as you can imagine, generated much debate. One of the more interesting rebuttals was the following:

“If a retired person has a portfolio of high-quality dividend growth stocks, the dividends will most likely increase every single year. Even during the stock market crashes of 2002 and 2008, my dividends continued to grow. The total value of the portfolio will indeed fluctuate every year, but that is irrelevant since the retired person is living off his dividends and never selling any shares of stock.

Dividends usually go up even when the stock market goes down.”

This comment is the basis of the “buy and hold” mentality, and many of the most common investing misconceptions.

Let’s start with the notion that “dividends always increase.”

When a recession/market reversion occurs, the “cash dividends” don’t increase, but the “yield” does as prices collapse. However, your INCOME does NOT increase. There is a risk it will decline as companies cut the dividend or eliminate it.

During the 2008 financial crisis, more than 140 companies decreased or eliminated their dividends to shareholders. Yes, many of those companies were major banks; however, leading up to the financial crisis, there were many individuals holding large allocations to banks for the income stream their dividends generated. In hindsight, that was not such a good idea.

But it wasn’t just 2008. It also occurred dot.com bust in 2000. In both periods, while investors lost roughly 50% of their capital, dividends were also cut on average of 12%.

While the current market correction fell almost 30% from its recent peak, what we haven’t seen just yet is the majority of dividend cuts still to come.

Naturally, not EVERY company will cut their dividends. But many did, many will, and in quite a few cases, I would expect dividends to be eliminated entirely to protect cash flows and creditors.

As we warned previously:

“Due to the Federal Reserve’s suppression of interest rates since 2009, investors have piled into dividend yielding equities, regardless of fundamentals, due to the belief ‘there is no alternative.’ The resulting ‘dividend chase’ has pushed valuations of dividend-yielding companies to excessive levels disregarding underlying fundamental weakness. 

As with the ‘Nifty Fifty’ heading into the 1970s, the resulting outcome for investors was less than favorable. These periods are not isolated events. There is a high correlation between declines in asset prices, and the dividends paid out.”

Love Dividends, Love Capital More

I agree investors should own companies that pay dividends (as it is a significant portion of long-term total returns), it is also crucial to understand that companies can, and will, cut dividends during periods of financial stress.

It is a good indicator of the strength of the underlying economy. As noted by Political Calculations recently:

Dividend cuts are one of the better near-real-time indicators of the relative health of the U.S. economy. While they slightly lag behind the actual state of the economy, dividend cuts represent one of the simplest indicators to track.

In just one week, beginning 16 March 2020, the number of dividend cuts being announced by U.S. firms spiked sharply upward, transforming 2020-Q1 from a quarter where U.S. firms were apparently performing more strongly than they had in the year-ago quarter of 2019-Q1 into one that all-but-confirms that the U.S. has swung into economic contraction.

Not surprisingly, the economic collapse, which will occur over the next couple of quarters, will lead to a massive round of dividend cuts. While investors lost 30%, or more in many cases, of their capital, they will lose the reason they were clinging on to these companies in the first place.

You Can’t Handle It

EVERY investor has a point, when prices fall far enough, regardless of the dividend being paid, they WILL capitulate, and sell the position. This point generally comes when dividends have been cut, and capital destruction has been maximized.

While individuals suggest they will remain steadfast to their discipline over the long-term, repeated studies show that few individuals actually do. As noted just recently is “Missing The 10-Best Days:”

“As Dalbar regularly points out, individuals always underperform the benchmark index over time by allowing “behaviors” to interfere with their investment discipline. In other words, investors regularly suffer from the ‘buy high/sell low’ syndrome.”

Behavioral biases, specifically the “herding effect” and “loss aversion,” repeatedly leads to poor investment decision-making. In fact, Dalbar is set to release their Investor Report for 2020, and they were kind enough to send me the following graphic for investor performance through 2019. (Pre-Order The Full Report Here)

These differentials in performance can all be directly traced back to two primary factors:

• Psychology

• Lack of capital

Understanding this, it should come as no surprise during market declines, as losses mount, so does the pressure to “avert further losses” by selling. While it is generally believed dividend-yielding stocks offer protection during bear market declines, we warned previously this time could be different:

“The yield chase has manifested itself also in a massive outperformance of ‘dividend-yielding stocks’ over the broad market index. Investors are taking on excessive credit risk which is driving down yields in bonds, and pushing up valuations in traditionally mature companies to stratospheric levels. During historic market corrections, money has traditionally hidden in these ‘mature dividend yielding’ companies. This time, such rotation may be the equivalent of jumping from the ‘frying pan into the fire.’” 

The chart below is the S&P 500 High Dividend Low Volatility ETF versus the S&P 500 Index. During the recent decline, dividend stocks were neither “safe,” nor “low volatility.” 

But what about previous “bear markets?” Since most ETF’s didn’t exist before 2000, we can look at the “strategy” with a mutual fund like Fidelity’s Dividend Growth Fund (FDGFX)

As you can see, there is little relative “safety” during a market reversion. The pain of a 38%, 56%, or 30%, loss, can be devastating particularly when the prevailing market sentiment is one of a “can’t lose” environment. Furthermore, when it comes to dividend-yielding stocks, the psychology is no different; a 3-5% yield, and a 30-50% loss of capital, are two VERY different issues.

A Better Way To “Invest For The Dividend”

“Buy and hold” investing, even with dividends and dollar-cost-averaging, will not get you to your financial goals. (Click here for a discussion of chart)

So, what’s the better way to invest for dividends? Let’s go back to our example of Exxon Mobil for a moment. (This is for illustrative purposes only and not a recommendation.)

In 2018, Exxon Mobil broke below its 12-month moving average as the overall market begins to deteriorate.

If you had elected to sell on the break of the moving average, your exit price would have been roughly $70/share. (For argument sake, you stayed out of the position even though XOM traded above and below the average over the next few months.)  

Let’s rerun our math from above.

• In 2018, an individual bought 100 shares at $80.

• In 2019, the individual sold 100 shares at $70.

Investment Return (-$1000.00 ) + Dividends of $323 (Yr 1) and $343 (Yr 2)  = Net Loss of $334

Not to bad.

Given the original $8,000 investment has only declined to $7,666, the individual could now buy 200 shares of Exxon Mobil with a dividend of $3.48 and a 9.3% annual yield.

Let’s compare the two strategies.

• Buy And Hold: 100 shares bought at $80 with a current yield of 4.35% 

• Risk Managed: 200 shares bought at $40 with a current yield of 9.3%

Which yield would you rather have in your portfolio?

In the end, we are just human. Despite the best of our intentions, emotional biases inevitably lead to poor investment decision-making. This is why all great investors have strict investment disciplines they follow to reduce the impact of emotions.

I am all for “dividend investment strategies,” in fact, dividends are a primary factor in our equity selection process. However, we also run a risk-managed strategy to ensure we have capital available to buy strong companies when the opportunity presents itself.

The majority of the time, when you hear someone say “I bought it for the dividend,” they are trying to rationalize an investment mistake. However, it is in the rationalization that the “mistake” is compounded over time. One of the most important rules of successful investors is to “cut losers short and let winners run.” 

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and strategy has horrid consequences.

As the virus crisis worsens in the US, employees at Amazon and Instacart are planning to strike today. 

Amazon workers at a New York fulfillment center are preparing to strike around lunchtime to call attention to the company’s “lack of safety protocols during the COVID-19 pandemic,” reported NBC New York. 

The union that represents workers at the Staten Island warehouse claims Amazon is more concerned about profits than the health of its employees: 

“All employers need to prioritize the health and safety of their workforce at this time. Unfortunately, Amazon appears to be prioritizing maximizing its enormous profits even over its employees’ safety – and this is unacceptable,” said Stuart Appelbaum, Retail, Wholesale, and Department Store Union (RWDSU) president.

Around 100 employees are expected to strike around noon on Monday outside the Staten Island warehouse. They are demanding the facility be closed for sanitizing. Recently, the e-commerce giant closed a warehouse in Queens after an employee contracted the virus. We noted last week that a total of ten Amazon warehouse employees across the country have tested positive in March. The workers are also requesting all employees at the facility to be compensated during the shutdown.

NBC New York obtained a statement from Amazon: 

“Like all businesses grappling with the ongoing coronavirus pandemic, we are working hard to keep employees safe while serving communities and the most vulnerable. We have taken extreme measures to keep people safe, tripling down on deep cleaning, procuring safety supplies that are available, and changing processes to ensure those in our buildings are keeping safe distances. The truth is the vast majority of employees continue to show up and do the heroic work of delivering for customers every day.”

Amazon says that all employees who test positive for COVID-19 will receive pay for two weeks. The warehouse in Staten Island will immediately start temperature checks of employees entering the facility. 

Workers for Instacart will also be staging a strike on Monday, demanding hazard pay and increased safety precautions to protect them from the virus. However, the strike will be nationwide. 

Instacart’s delivery workers are demanding hazard pay of $5 per order, freehand sanitizer, and disinfecting wipes, and paid sick leave for workers with pre-existing medical conditions. 

The whole debate of profits over human health is gaining traction as the pandemic ravages the Northeast. 

Companies are soon going to recognize they are nothing without their low-income workers as many are starting to walk off the job due to hazardous health conditions related to the virus. 

“This could be devastating.” A number of workers for two delivery service giants, Amazon and Instacart, are preparing to go on strike. They’re demanding added protections from the coronavirus and a boost in pay because of a massive increase in business, @SamBrockNBC reports. pic.twitter.com/6zQpodtCf1

— TODAY (@TODAYshow) March 30, 2020

Walking off the job and strikes could be the early beginnings of social unrest forming in the US. The Federation of Red Cross and Red Crescent Societies warned last Friday that riots and protests could hit major Western cities in the next several weeks.

In a stunning miss to expectations, March’s Dallas Fed Manufacturing Outlook survey crashed like never before (from +1.2 in February to -70.0 – massively below the -10.0 expectation).

Source: Bloomberg

As you can see, this is the weakest level ever and the most aggressive collapse ever. As one trader mocked when the data hit, “…is that a bad print?”

The measures production and new orders both were lowest since 2009.

The figures are consistent with severe declines in other regional gauges as unprecedented shutdowns freeze large parts of the industrial economy. Regional Fed bank measures of manufacturing in New York, the Philadelphia area, and Kansas City district all showed record monthly declines.

Source: Bloomberg

Of course, Texas has been hit with both barrels of collapse as the oil price war and national virus lockdown crush markets.

Authored by Bill Blain via MorningPorridge.com,

“Damn, he was good. Came out of nowhere. Hit us with a full broadside, cut across our tail and took out our rudder. Damn fine gunnery.”

According to the press, China is experiencing normal traffic jams, while the major threat is reinfection from the West, so borders are locked shut. They are anticipating business as usual. They are in for a shock. 

JP Morgan are on the wires saying markets have made their lows, and although it will be volatile, its time to “average into oversold markets.”

In my opinion… they are fools. 

I suspect this is going to be a very very bad week for markets. 

April is going to hurt. Last week’s rumbustious rally on the back of kitchen sink government fiscal promises, QE infinity and “the boys will be home by Chistmas” market optimisim, is going to be crushed. The flow is about to get much worse, in a trifecta of economic, business and virus news. 

We are about to learn a sharp brutal lesson about expectations versus reality:

• There is no swift end in sight. The UK has been warned to expect months of distancing. Trump isn’t reopening the economy for Easter – he’s closing America down till May.

• Oil prices have crashed below $20. 

• Rising economic damage, business failures, and confirmation of massive unemployment – especially in US – will come to fore in this week’s data and numbers through the month. Government support packages will take months to become established – months the markets don’t have.

• Aside from a few ultra-high Investment grade cash-rich corporates, there is a massive industrial scramble for cash underway. Anyone able to raise cash should lift any offer – before a slew of downgrades and defaults closes credit markets completely. 

• Emerging Market economies were pummelled by dollar strength, are now about to be devasted by the global virus demand shock, and as virus countermeasures hits already unstable nations could well plunge into chaos. 

• Market chartists will tell you optimistic bear rallies are a standard part of every market crash – and the bottom will be retested a number of times. 

• There is still pain to come. There are a large number of investors – both institutional want-to-be’s (like JP Morgan) who buy the stimulus and are thinking there are easy returns to be made after such a large “correction”, and retail buyers who are fearful their retirement savings have been shattered who are willing to shake the dice. They can’t quite believe what’s happened, don’t compute the scale of the economic shock, and won’t face up to a changed world till they take more pain.

If any of these are positive reasons to sustain last week’s rally, feel free to explain in the comments section of the Morning Porridge below. 

A number of good analysts suggest the chances of a swift recovery are better than the bleak headlines suggest. They quote issues like obvious market opportunities will swiftly attract smart money – which is true, and the natural resilience of capitalist economies in the face of economic catastrophe – which was once true. 

I hope they are right, but I wonder about human economic behaviour – which tends not to have read Rational Expectations economic text-books. What tends to happen is at the individual agent level, where they seek to maximise personal gain by arbitraging distortions like government bailouts and free money in unexpected ways. 

Not every entrepreneur will use a government guaranteed loan to tide over their business – some may use them to wreck the competition, enrich themselves, invest in risk, or act in a thousand other ways. Market distortions and interventions have unintended consequences which ultimately prove negative – a lesson governements and central banks have been trying to ignore for the last decade of monetary distortion and experimentation. 

(If you don’t believe me, explain why thousands of corporates spent the last decade buying back their stock instead of investing in new productive capacity and new product innovation?)

Get ready for a long-haul of increasingly dire economic news. A month – at least – of Lockdown helplessness, as corporates and individuals scramble for cash, struggle to obtain funds and face unmeetable demands for rent, mortgages, and to pay off debts. It’s going to be brutal. 

Is there any good news? 

Perhaps in the virus itself – but this isn’t about the Wuhan flu. It’s about the economy. In the absence of real data in many countries due to the lack of testing, we’re forced to make guesses. But the trends are showing infections rise (as testing kicks in) and a falling mortality percentage. The pace of mortality deaths is declining – as was expected to happen as lockdowns lower the R transmission rate and the all-important “critical cases in hospital” curves. We will find out how successful its’ been in coming days. 

On the other hand, the first obituaries of coronavirus victims are appearing; including a number of fit, middle aged men, demonstrating the random nature in terms of victims and symptoms. 

To tell a story: after struggling with the disease for over a week, a fit chap in his late fifties I know in London ended up in Hospital, (and fortunately got better quickly once given oxygen and sent home). Meanwhile his partner and her daughter are showing zero symptoms and feel absolutely fine (although badly traumatised by his illness), despite all being cooped up together in a London flat.

The virus storm will likely escalate across North-West Europe and the US this week, while plateaus across Italy and Spain are expected. Will Europe reopen as quickly as China – unlikely because there has been less testing, less source tracing and very little real information to base decisions upon. 

Don’t be fooled – as markets were last week – that there is an easy and quick answer to this crisis. However, there are definitely investment opportunities out there. The trick is grabbing them and holding on through the coming storm..

Over the weekend, we reported that with the oil industry oversupplied by a mindblowing 20 million barrels daily as roughly 20% of total global output ends up unused in a world economy that has ground to a halt, and instead has to be parked in storage either on land or sea, the unthinkable is about to happen: oil storage space is about to run out, and as that happens the price of oil will continue sliding ever lower and lower until it finally goes negative as some such as Mizuho’s Paul Sankey predict it will, over the next few months, leading to an unprecedented shockwave across the global energy market.

Then overnight, more eulogies for the oil market emerged, with Bank of America writing that oil has now slumped “into the abyss” and it expects to see the “steepest decline in global oil consumption ever recorded, with our base case reflecting a 12mn b/d drop in 2Q20 and a 4.5mn b/d contraction on average for the year” and on a net basis, BofA now expects global oil demand to contract by almost 17mn b/d in April with consumption recovering modestly into 3Q20 and beyond.

The bank also adjusted its oil price forecasts for 2020 and 2021 down to $37 and $45/bbl for Brent and to $32 and $42/bbl for WTI respectively, but in the near-term, it sees both benchmarks temporarily trading in the teens in the coming weeks.

However, by going all “there will be blood” on oil, BofA has only caught up where Goldman has been for the past two weeks, ever since it predicted that the “physical end was near.” Meanwhile, in a note of unprecedented gloom, Goldman now says that “the physical end is here” as the coronacrisis goes global.

As Goldman’s Jeffrey Currie calculates, the oil surplus generated by an unprecedented demand shock has begun to hit physical constraints at refineries, pipelines and storage facilities, “leading to at least 0.9 million b/d of announced shut-ins at the wellhead, with the true number likely higher and growing by the hour.”

With social distancing measures now impacting 92% of global GDP, the ultimate magnitude of these shut-ins which is still unknown will likely permanently alter the energy industry and its geopolitics, restrict demand as economic activity normalizes and shift the debate around climate change.

In other words, what is taking place now is “not only is this the largest economic shock of our lifetimes” but from a practical perspective, “carbon-based industries like oil sit in the cross-hairs as they have historically served as the cornerstone of social interactions and globalization, the prevention of which are the main defense against the virus.”

Accordingly, oil has been disproportionately hit, likely more than 2x economic activity, with demand this week down an estimated 26 million b/d or c.25%.

As a result, and picking up on what we said over the weekend, Goldman now warns that “this shock is extremely negative for oil prices and is sending landlocked crude prices into negative territory.” Of course, it is only a matter of time before this ultimately creates an inflationary oil supply shock of historic proportions because so much oil production will be forced to be shut-in, but first we need to see prices close to zero… or below it.

Currie next focuses on the storage conundrum we discussed yesterday, and how – as we warned – this will lead to negative oil prices:

The global economy is a complex physical system with physical frictions, and energy sits near the top of that complexity. It is impossible to shut down that much demand without large and persistent ramifications to supply. The one thing that separates energy from other commodities is that it must be contained within its production infrastructure, which for oil includes pipelines, ships, terminals, storage facilities, refineries, and distribution networks. All of which have relatively small and limited spare capacity. We estimate that the world has around a billion barrels of spare storage capacity, but much of that will never be accessed as the velocity of the current shock will breach crude transportation networks first, which we are already seeing evidence of around the world. Indeed, given the cost of shutting down a well, a producer would be willing to pay someone to dispose of a barrel, implying negative pricing in landlocked areas.

The good news, however, is that from the devastation that will follow in the coming months, a new – and far more viable – industry will emerge, or as Currie puts it “the current oil crisis will see the energy industry finally achieve the restructuring it so badly needs. We have long argued that it is the supply and demand of capital that matters, not the supply and demand of barrels; as long as there is capital, companies can withstand difficult periods and the barrels always come back.”

The rest of his full note is below:

Waterborne crudes like Brent will be far more insulated, staying near cash costs of $20/bbl with temporary spikes below. Brent is priced on an island in the North Sea, 500 meters from the water, where tanker storage is accessible. In contrast, WTI is landlocked and 500 miles from the water. This illustrates an important point. Shut-ins will be not be based upon where wells sit on the cost curve but rather on logistics and access. High-cost waterborne crude oil that can reach a ship (storage we have historically never ran out of), are better positioned than landlocked pipeline crude oil sitting behind thousands of miles of pipe, like the crude oils in the US, Russia and Canada. In 1998, when surpluses last breached storage capacity, it was these landlocked crude oils that were the hardest hit. So while markets like WTI, particularly WTI Midland, or Canada’s WCS can go negative, Brent is likely to stay near cash costs of $20/bbl. Ultimately, the market never hits nameplate capacity, as other bottlenecks are also at play. During 2008 and also in this crisis, dollar funding and credit constraints that prevent oil owners from accessing storage and transportation capacity also played a role. We believe that the Fed’s actions last week alleviate some of this risk, but oil itself creates dollar liquidity given its importance in global trade and setting the price of other traded goods and another sharp drop in oil prices could create additional dollar shortages.

The oil price war is made irrelevant by the large decline in demand and has made a coordinated supply response impossible to achieve in time. A month ago, the logic of the price war made sense when the demand shock was c.5.0 million b/d. It gave OPEC and Russia the first opportunity since 2012 to completely undercut shale, and finally reverse the production cut in 2016 which we believe never made economic sense to begin with. Not only did OPEC producers sacrifice $220 billion in lost revenues (annually at $60/bbl Brent) and market share, but so did the equity and debt shareholders of higher-cost producers. The artificially higher prices distorted incentives for oil investment, leading to inefficient capital spending by these companies that, by our estimates, destroyed roughly $1.0 trillion worth of market cap since 2016. The policy of production cuts was a strategic error, not only to OPEC+ countries, but to all equity and debt owners in the industry. Now the question is: can the US and OPEC save this market? The demand shock has become so large that they can’t do it alone, a fact they have acknowledged, stating that a balanced market would require a coordinated global production cut — a policy which appears impossible at this point, too late to stop the current surplus and far below other initiatives on the agenda right now.

The key to how quickly prices rebound after this supply shut-in will depend on how much inventory is built. Markets are already hitting transportation bottlenecks without having filled storage capacity. Oil in Canada is now near $5/bbl and WTI Midland $13/bbl with Cushing inventories still only half full. The quicker and harder these capacity constraints are reached, the quicker and more violently the market will rebalance when production shuts in, and the quicker deficits return to the market, putting upward pressure on prices. In the bear market of 2015/16 production shut-ins were based upon a producer position on the supply cost-curve. Unlike then, the logistical nature of the shut-ins suggest they will be completely indiscriminate, inflicting substantial damage on the wells that in some cases will be permanent. Once economic activity begins to normalize, the deficits will likely be substantial as the rebound in demand will be constrained by supply that has been damaged by the shut-ins. This could potentially require continued destruction of commuting and jet fuel demand. Net, if pipelines get clogged up as refineries shutdown, inventories cannot build, reducing the cushion and creating a very quick risk reversal towards oil shortages that could push prices far above our $55/bbl target for next year.

This will likely be a game-changer for the industry. Once you damage the capital stock in oil it is an expensive and time-consuming process to rebuild, assuming it can be rebuilt at all. This contrasts with the rest of the economy where the capital stock is sitting idle and ready to restart, which is why it is expected to exhibit a V-shaped recovery. In contrast, we believe the upstream sector could lose as much as 5.0 million b/d of oil supply capacity. With that much supply loss the industry will unlikely be able to rebound even close to old demand levels without creating substantial price appreciation, the scale of which will be determined by how much inventory is built in the coming weeks. In addition, the geopolitical landscape is also changing. We note the current political situation in Venezuela, where further US sanctions have been imposed for over half a year and where Rosneft divestitures of oil assets occurred over the weekend. At the same time, Iran has been heavily impacted by the coronavirus, which follows the rise in tensions between the US and Iran in January, during which oil reached its recent peak of $70/bbl. On top of this, there could be further geopolitical instability generated by the extreme economic conditions forced upon the many oil producers in Africa and Latin America.

Oil and gas fields are far different from other manufacturing processes. They are organic deposits and as such have decline rates, having shut an older well it may not be economic to bring it back online. Most of these older, more depleted and less productive wells are onshore, not offshore, which makes them the most vulnerable to shut-ins. We believe shut-in economics will be driven by three factors: 1) crude net-backs (driven by local infrastructure constraints and crude quality); 2) variable cash costs (highest in mature fields with low flow rates); 3) decommissioning liabilities (most material for offshore deep-water fields). As such, we believe that shut-ins are most likely at onshore, mature, depleted, heavier and sourer oil reservoirs in countries like Canada, the US, Russia, Latin America and China. Offshore fields are least likely to be affected, due to their generally higher crude quality, lack of infrastructure constraints and high decommissioning liabilities. Mature, heavier oil, high water-cut reservoirs will also suffer the most from a prolonged shut-in and may not return to their pre-shut-in production capacity once oil demand increases.

We believe the current oil crisis will see the energy industry finally achieve the restructuring it so badly needs. We have long argued that it is the supply and demand of capital that matters, not the supply and demand of barrels; as long as there is capital, companies can withstand difficult periods and the barrels always come back. The difference between today and 2015/16 is that shale and high-cost oil producers were already facing sharply higher costs of capital over the past year due to persistently poor shareholder returns. Indeed, these capital restrictions have only been exacerbated by recent events, whereas in 2015/16 capital never dried up – making the likelihood of capitulation by US E&Ps and EM producers much higher today. Further, the rebalancing phase in our New Oil Order framework was cut short in 2016 by Chinese stimulus that boosted demand followed by OPEC+ production cuts that curtailed supply. In the end, we never saw the final regeneration phase of rationalized assets that would have created a more sustainable industry over the longer term.

Today, we have already seen uneconomic firms shut off from capital. This suggests that the overdue rationalization of the industry is finally set to occur. We believe it will be very selective with a clear focus on upgrading portfolios: Big Oils will consolidate the best assets in the industry and will shed the worst assets. There will be local consolidation amongst E&Ps, and when the industry emerges from this downturn, there will be fewer companies of higher asset quality, but the capital constraints will remain. Capital markets focused on de-carbonisation and lack of visibility over long-term demand will constrain the remaining firms, leading to structural underinvestment and higher corporate returns, bringing an end to energy’s lost decade. Only a significant supply shortfall once demand recovers could slow this much-needed industry consolidation and rationalization. A large, sustained deficit would lead to much higher prices until even marginal shale producers respond, as they remain the fastest cycle source of supply.

The climate change debate will almost certainly take a different course when the global economy emerges from this and is faced with the prospect of having to make large-scale investments into carbon-based industries. The silver lining of the coronacrisis is that the virtual shutdown of key carbon industries – autos, airlines and cruise ships –
is likely to cause carbon emissions to fall this year, with initial data from China pointing to a c.20%+ fall during the peak of the shutdown. It is important to emphasize how the current shock is hurting the unsustainable industries but encouraging sustainable industries. The aircraft and migrant workers that used to bring the world fresh fish, fruit and vegetables have been stopped.

Technological hysteresis is already occurring. People are adapting to a more local existence and living off more sustainable activities, consuming less globally-produced fresh food, producing less waste with a more conservative approach to consumption, all of which may have lasting impacts on demand. Further, commuters and airlines account for c.16.0 million b/d of global oil demand and may never return to their prior levels. While oil prices are low today and physical constraints are forcing the behavioral changes, as oil shortages develop once economic activity normalizes, the high oil prices will likely accelerate the energy transition by constraining demand. For example, commuting and jet demand destruction may still be needed to cope with the supply shortage that is likely to occur once significant supply capacity is hampered. Higher oil prices would also greatly improve the relative economics of EVs and hydrogen. But from the supply side, capital markets’ push for de-carbonization is likely to prevent the broad investment the industry will need to get out of this crisis and will reinforce a tight physical market beyond 2020.

Low returns in energy and commodities have been referred to as a lost decade. Oil has handed investors losses of about 8% per year since 2010. However, we believe that a bottom will be carved out in the coming weeks or months that will serve as the foundation for solid future returns similar to 1999. Combining these potential supply constraints with the large fiscal stimulus in response to the virus, we believe that physical inflationary concerns – with the dollar starting near an all-time high – will finally dominate the financial asset inflation that was a feature of the past decade that acted as a drag on energy and commodity returns. In the very near-term, however, we would play it from the short side. Nonetheless, we must keep in mind the fact that each downturn has become increasingly shorter in duration as the system has been able to adapt more quickly, and although oil prices are likely to further decline in the coming weeks, it is important to start focusing on the transition.

Once again, pending home sales will be the tie-breaker for February housing data (existing sales soared, new sales slipped) and expectations were that it would be weaker (after a huge surge in January) but instead it surged 2.4% MoM (vs 1.8% drop expected).

January’s upwardly revised (from 5.2% to +5.3%) spike was the highest since Oct 2010 and the YoY rise in sales of 11.5% is the highest since April 2015

Source: Bloomberg

This is the highest level (SAAR) of pending home sales since April 2016…

Source: Bloomberg

Pending sales last month increased in all four regions, led by a 4.6% gain in the West and a 4.5% advance in the Midwest. The index for the South, the largest region, was the highest since March 2006.

“Housing, just like most other industries, suffered from the coronavirus crisis, but once this predicament is behind us and the habit of social distancing is respected, I’m encouraged there will be continued home transactions though with more virtual tours, electronic signatures, and external home appraisals,” Lawrence Yun, NAR’s chief economist, said in a statement.

Yun noted that the data do not capture the fallout from measures taken to control the outbreak.

So the question is – have homebuilder stocks over-reacted or are we just not seeing the impact of COVID-19 lockdowns in the data yet?

Source: Bloomberg

We suspect we know which.