Looking out into the future, markets and economies will driven in large part by falling prices in a few major areas:
- Falling Oil Prices
- Crashing Prices and Excess Capacity in Commodities
- Diverging Monetary Policies and the Strong Dollar
Falling Oil Prices
Last week oil fell to $36/barrel, going below $40 for the first time in six years. Earlier in December OPEC had its final meeting for the year, and at this point I think it is fair to say OPEC has become completely irrelevant. A cartel that has no ability to control the production of its members is no cartel. OPEC can’t control its members because Saudi Arabia already learned its lesson in the 1980s, when it cut production in response to falling oil prices and ended up mostly just losing market share. Other nations paid attention. On top of that, these countries’ budgets are in dollars, as oil is priced in dollars, and they need to keep up their spending in order to maintain control over their citizen – the perpetual challenge for countries in which the primary source of national income is owned by the State.
So why are oil prices falling? Simply because while demand is growing, it is growing at a slower rate than supply. The high oil prices from years ago combined with the Fed’s ZIRP (Zero Interest Rate Policy) and technological breakthroughs in oil extraction technology, led to an influx of investing in oil production capabilities which was funded in part by a lot of high yield debt. As the price of oil continued to fall, many of the companies have found themselves in violation of debt covenants. This is leading to rising defaults, (although the default rate today in aggregate is not at historically high levels) which then leads to tightening of credit conditions as lenders are forced to rebalance their lending portfolios. This make conditions even more challenging on these distressed firms, as credit is increasingly less available, which will eventually lead to bankruptcies for many of the more highly-levered firms. We saw a similar pattern back in the financial crisis as the real estate investing boom blew up in spectacular fashion when borrowers were unable to refinance on major portions of their real estate portfolios, even on properties that may have had more than 50% equity, resulting in a complete wipeout of their clients’ invested capital in those properties.
The good news for investors is that this is also reminiscent of the heady days of the Dotcom boom when all the rage was broadband infrastructure, with high-fliers such as Global Crossing, which eventually flamed out in headline grabbing bankruptcies that wiped out most debt and equity holders alike. However, that led to the ability for those that survived the carnage to be able to pick up that infrastructure for pennies on the dollar, leading to materially lower broadband pricing, which facilitated the next wave in the Internet evolution. I think oil is likely to experience something similar, with those companies that have healthy balance sheets being able to pick up production capacity at pennies on the dollar, greatly improving their overall margins and providing the economy with lower-cost energy into the future, which will be a much appreciated tailwind. For now, I think it best to avoid this sector, but at some point in the near-to-mid future it will provide spectacular opportunities. This lower-price oil will also be a fantastic boon to those emerging economies that are big energy importers, helping their economies grow at a faster pace than was previously possible, providing investors with yet another great opportunity. U.S. lawmakers are also expected to lift the ban on oil exports as part of the current spending bill legislation, which will provide additional support for domestic producers.
For now, the defaults and struggle in oil will be a strain on the overall economy. For those who point out that oil and gas drilling accounts for only around 4.6% – 6.5% of GDP, residential housing makes up around 5% of GDP and we all recall just how much damage excessive investment and use of debt in that sector did.
Crashing Prices and Excess Capacity in Commodities
Commodity prices have been falling for years, with the CRB commodity index down 21% from just its May 2015 highs. An entire book could easily be written on this topic, so I’ll narrow it down to just a few illustrative points in the interest of preserving your sanity! The last major commodity super-cycle began when China was allowed entrance into the World Trade Organization. Thanks to the enormous shift in its population from rural agrarian to industrial manufacturing, it was able to supply the world with cheap labor, which meant cheaper products for exports. The money it took it was funneled into gobbling up commodities to use in its eye-popping infrastructure build out; for example, China accounts for about half of the world’s aluminum consumption.
During and after the financial crisis, the world greatly benefited from China putting its pedal to the metal on its infrastructure build out, effectively creating a floor under commodity prices and protecting commodity producers from what would have been a much more painful fall without China’s purchasing. To put in it context, in 2009, with the markets crashing, oil stood around $100/barrel and steel plate was at $600, today oil has fallen below $40 and steel is at $260.
Today China’s steel production capacity is around 400 million tons a year, which is nearly four times the U.S.’s capacity at 120 tons. With China’s slowing economy, and more importantly rapidly slowing infrastructure build, it has more and more excess capacity. China’s steel consumption is declining for the first time in two decades, with the nation’s steel sector experiencing layoffs in the tens of thousands. Year-to-date the one hundred largest steel companies lave lost around $11 billion with 37 steel plants closing so far.
Most of China’s excess capacity cannot be shipped to the U.S. as it is of lower quality and is barred by tariffs, but it can go to Europe where prices are crashing and has caused quite the crisis in the U.K. European players have been forced to continually lower prices and unlike China, they can export to the U.S.; despite the tariffs, U.S. steal producers cannot be totally insulated.
Many of these steel and oil mid-cap companies have “crossover” bond ratings, which means they are in-between investment grade and junk status, (BBB and BBB-). All it takes is one little nudge and they will be in junk territory, which means then that the funds that hold them will have to rebalance their portfolios which in turn affects the credit market as a whole. Here too, those producers that maintain healthy balance sheets and do what they can to raise cash, will be able to goggle up bankrupt production capacity at below-cost, lowering their margins and allowing for lower cost steel into the future, which will help not only domestic users, but will be particularly beneficial for those emerging market, commodity importing nations. While I’ve only talked about oil and steel in depth here, similar dynamics have and are occurring in other commodity markets across the globe.
Diverging Monetary Policies and the Strong Dollar
The strong dollar continues to be one of the most common problems cited by companies in their quarterly reports. So what does it mean, why is it happening and is it likely to continue to strengthen?
The dollar began strengthening when the Federal Reserve first pulled back on its quantitative easing programs. This directional shift marked the first step. Then it ceased quantitative easing altogether, whilst other nations continued or even accelerated their programs. Now the Fed has raised interest rates, which further strengthens the dollar against other currencies. As other nations around the world engage in stimulative monetary policies, the dollar will further strengthen against them.
Commodities are globally priced primarily in dollars. I just walked you through falling oil and steel prices and as those prices have fallen, dollars have essentially been disappearing into thin air. By that I mean, imagine you have drilled an oil well or built a steel plant. When you did so, you forecasted a certain productive capacity that would result in a dollar value of sales based on an assumption of price. Falling prices have cut your expected sales enormously, meaning dollars you expected to have in your pocket will never show up. This means that your investors and/or creditors are not in the same position they expected to be – you don’t have the dollars you were expected to have, so no wonder there is an increased demand for dollars.
This brings us to the $9.5 trillion dollar carry trade which I’ve talked about before in the October 2014 issue, where I explained how the carry trade works, and again in August of this year. The higher the dollar goes, the greater the demand for dollars to pay back that dollar denominated debt. If we look at history, there are two main dollar bull markets. The first one was in the 1980s that only ended after the world’s central bankers got together in the Plaza Accord to weaken the dollar after it had risen about 100%. In the late 1990s, we experienced a second bull run which ended in the Asian Crisis after the dollar had appreciated about 50%. During both, the dollar experienced pullbacks, but never of more than 10%, which gives us a potential metric to mark this bull run. Today, we have the largest global carry trade ever seen, which makes the bigger picture look closer to the 1980s. Looking at the data, there is a material probability that the dollar strengthening process could start to accelerate again, which will put more downward pressure on commodity prices. I think being long the dollar and even owning longer-term bonds while either being short or just staying away from the commodity complex would be the wiser move here. (Hat tip to Raoul Pal of Real Vision Television for some of the research on the dollar bull runs.)
As for longer dated bonds, if the Fed continues to raise rates and the economy is in fact slowing and the rate hikes weaken the economy further, then growth expectations will slow which will cause longer-dated bond yields to drop and bond prices to rise. If the Fed continues to raise short-term rates, an inverted yield curve, (in which short-term rates are higher than long-term rates) is possible, which would be very damaging for banks as they borrow short-term and lend long term. If the dollar continues its rally, demand for bonds will rise as well, which will push up bond prices and push down bond yields. Bond prices could however get hit if the Fed hikes, but hikes much more than is expected, which given the reasonably dovish commentary Wednesday, currently seems unlikely.
Bottom Line: We are in unchartered territory in many areas; higher levels of sovereign debt than during the financial crisis, a bigger U.S. dollar carry trade than the world has ever seen, more excess reserves at the federal reserve than ever before, tectonic shifts in global economic power and rising political tensions throughout much of the world coupled with challenging demographic trends, (aging populations) in the U.S., Europe, China and Japan while many emerging economies are blessed with a much lower median age in their populations. Never before in the modern era of high-yield bonds has the Fed hiked rates when the high-yield bond spread was greater than 6.25%; today it is 7%. Over the next decade the “it” places to invest are likely to be economies that were previously not on many investors’ radars. We are likely to face some challenging times, but those inevitably lead to wonderful opportunities. 2016 will probably give us some