“Life can only be understood backwards; but it must be lived forwards.” ― Søren Kierkegaard
This week’s piece comprises a few charts and ideas that stem from those charts.
Before getting to the charts, however, we want to address two unrelated points — the second may qualify as a rant.
1. The short-lived coupling of bonds and equities, where both asset classes sold off concomitantly, has been seen by some market participants and commentators as an indication of the market suddenly becoming acutely aware of the risk of rising inflation. Specifically, the broad-based fiscal and monetary measures being taken by governments and central banks leading to a sudden rise in inflation.
While we do consider the official measures being taken, to soften with economic blow from the COVID-19 pandemic, to be sowing the seeds of inflation at some hitherto unknown point in the future, we consider the recent sell-off in bonds to be indicative of:
- liquidation, where assets are sold off irrespective of price to meet investor redemptions and / or margin calls;
- foreign central banks and large pools of capital (e.g. pension funds and life insurers) monetising high quality assets to secure US dollars; and
- some level of profit taking by speculative accounts (e.g. hedge funds) after the sharp move lower in yields.
For as long as demand, specifically consumer demand, remains capped by the drastic measures being taken to “flatten the curve” and we do not reach a stage where demand far outstrips supply, we consider any discussion over fears of a sudden spike in inflation to be premature. Moreover, if the absence of demand, exacerbated by a shortage of US dollars, leads to a spiralling credit default cycle, the deflationary impulse in the global financial system will overpower any and all of the measures being taken by central banks and governments.
As we have said on a number of occasions, a deflationary bust is likely to precede runaway inflation.
Why?
A deflationary bust is what we think brings about the next big Lehman-like casualty amongst the global banking behemoths. In response to which the authorities would have to take unprecedented measures that devolve into a loss of confidence in the major currencies, namely the US dollar and / or the euro.
Do not position the core of your portfolio for rampant inflation or an end-of-fiat currencies type of regime change, at least not yet.
2. At times we hear or read commentators and market participants discussing the “foreseeable future”. For example, “the COVID-19 pandemic has changed the world for the foreseeable future” or “markets are likely to remain volatile for the foreseeable future”.
To that we ask: How much of the future is foreseeable exactly?
The only correct answers to the question are (a) none of it or (b) absolutely none of it.
Certain events are “foreseeable”, say sunset, and certain events are “highly probable”, such as a company with high levels of debt and generating negative free cash flow defaulting during a financial crisis. Even those are few and far between.
Pro-tip: Ignore any recommendations that are based on knowledge of the foreseeable future.
Rant over. On to the charts.
Charts & Ideas
Crude Oil Contango
Definitions:
Contango is the situation in which the spot or cash price of a commodity is lower than the forward price.
Backwardation is the situation in which the spot or cash price of a commodity is higher than the forward price.
The above chart is of the spread between the price per barrel of Brent crude due for delivery in six months from now and that due for delivery in the current month. When the line is above zero, crude oil is said to be in contango and when it is below zero it is said to be in backwardation.
Since OPEC and Russia instituted the policy of supply cuts to rebalance the oil market, the crude oil market was largely in backwardation. That is, immediate supply was (artificially) constrained and the market expected prices to fall once supply was reinstated.
With Saudi Arabia and Russia entering a price war and the price of crude collapsing, the current price is, according to oil market participants, not seen to be sustainable. Current prices are deemed too low to sustain for oil producers be it shale, Russia or Saudi Arabia. Hence, the market has gone into contango.
When a commodity market goes into contango, traders are motivated to hoard supply by buying in the current month and immediately lock in a profit by selling a for delivery futures contract for delivery at some future date. This is exactly what is happening in the oil market.
To hoard oil, traders are required to lease very large crude carriers (VLCCs) and store their oil on these vessels till such time that the delivery has to be made.
The economics of the trade are the spread between spot and future oil prices multiplied by the number of barrels stored for future delivery less the cost of leasing and operating the VLCC till delivery. (VLCCs are leased based on daily rates, unless chartered on long term contracts — something primarily reserved for oil companies and not traders.)
Based on some back of the envelope calculations, and subsequently confirming with shipping brokers, the rule of thumb is that a US dollar 1 spread between spot and the 6 months futures price supports a VLCC rate of roughly US dollars 10,000. That is, traders are willing to pay a daily lease rate of US dollars 10,000 per vessel for each dollar of spread between spot and the futures price.
The current spread as per the above chart is approximately US dollars 10. That should support daily VLCC rates of approximately US dollars 100,000. Depending on the shipping route, VLCC rates are currently averaging around US dollars 100,000 per day. To put that in context, over the last two decades, VLCC rates have averaged approximately US dollars 20,000 per day. Suffice to say, it is a good time to be an owner of a VLCC.
According to a shipping broker we spoke to:
“As long as Saudi keeps the pumps open and demand remains weak, this trend is likely to continue – we believe 15 to 20 VLCCs has been taken up for storage up until now.”
To play this theme, one should buy stocks such as Scorpio Tankers $STNG, Frontline Ltd $FRO and Teekay Tankers $TNK.
USA versus the Rest of the World
Last week we shared a chart of a proxy for the size of the Eurodollar banking system versus that of US money supply M2. In the chart below, the magenta line is the ratio of US M2 to the Eurodollar proxy. While the yellow line is the ratio of the performance of the S&P 500 Index to the performance of the MSCI All Cap World ex. USA Index.
Until such time that we witness an easing of US dollar shortages in the rest of the world, there is little to no reason to prefer non-US markets to US markets, broadly speaking.
Consumer Staples to Consumer Discretionary
Last chart for this week.
The above chart is a ratio of the consumer staples index to that of the consumer discretionary index. A rising line implies that staples are outperforming discretionary consumer plays.
The last decade has come to be characterised to a certain degree by the growing disparity between the haves and the have nots, by wealth inequality. The rich are more likely to engage in conspicuous consumption. If you look at the consumer brands that have risen to new heights over the last decade — Apple, Lulu Lemon, Louis Vuitton and the brands under the LVMH umbrella, Peloton, etc. — they almost exclusively position themselves to appeal to the classes over the masses. That trend for now at least has been arrested — no one goes shopping for luxury bags when they are worried about catching a virus but everyone needs to eat, wash and clean.
For as long as the COVID-19 pandemic does not subside, we continue to prefer staples. Especially the ones with the most robust supply chains.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.