“Our analysis leads us to believe that recovery is only sound if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own.” — Joseph Schumpeter (1883—1950)
Oil and Energy Stocks Disconnect
For the one-month period ended 23 April, the front-end WTI crude futures contract is down 29.4 per cent. Concurrently, the Energy Select Sector SPDR Fund $XLE is up 46.5 per cent. A delta of 75.9 per cent. Quite the disconnect, or so it seems anyway.
(As the major holdings within $XLE are that of oil majors such as Exxon and Chevron, it serves as a fairly good proxy for the performance of the US oil majors.)
The thing about oil majors is that they generate a very small portion of their value from the barrels of crude they sell any given day; or any given month, for that matter. Rather, the vast majority of their value is derived from their respective reserves i.e. the estimated amounts of crude they hold underground.
While all headlines are about the crash in front month prices, back-end prices have risen. Back-end prices are up more than 15 per cent over the last month. That is, what the oil majors hold in the ground has become more valuable even as selling prices today are lower. Since, the value of reserves far exceeds the value derived from near-term cash flows, oil major stocks are up even as spot crude prices are down.
Global Banking
“The process by which banks create money is so simple that the mind is repelled. When something so important is involved, a deeper mystery seems only decent” — John Kenneth Galbraith (1908—2006)
The below chart is of the relative performance of US, European and Japanese banks relative to their respective broader market indices. (All three ratios have been indexed to 100 at the start of the time series.)
Shareholders in banks, be it in the US, Europe or Japan, have not had the greatest run. In hindsight, one the keys to outperforming broader market indices since the Global Financial Crisis would have been to simply avoid banks.
On a shorter-term time frame (say 3 to 18 months), capital markets are largely driven by the ebbs and flows of liquidity. That is, in Benjamin Graham’s parlance, market behave much like voting machines in the short-term. While on a longer-term timeframe, markets come to reflect the underlying fundamental conditions of the economy, sector and specific company. That is, markets behave much like weighing machines over the long-term.
Given the prolonged under performance of banks, across major global markets, suggests the market has ‘snuffed out’ that there are real issues plaguing the global banking system. To circle back to the Schumpeter quote at the very beginning of the piece, the global banking revival has been “merely due to artificial stimulus” which has left “part of the work of [recession] undone”. That is, after one extraordinary policy measure after another, the global banking system has been surviving on “artificial stimulus” rather undergoing a wholesale recovery.
Why is that?
A few weeks ago, we outlined the Eurodollar system and how its inability to grow was translating into the relative under performance of the rest of the world versus the US. In that piece, we identified a time series published by the Bank for International Settlements, as a suitable proxy for determining the size of the Eurodollar system. With the aid of the below chart, we take that discussion a step further this week.
In the above chart, the Eurodollar proxy is plotted against, another time series provided by the Bank for International Settlement — global over-the-counter (OTC) derivatives outstanding, using notional not netted amounts.
A quick primer on OTC derivatives. An investment bank writes a swap or OTC derivative — essentially a form of speculation being undertaken by a client – say for a notional long position exposure on US dollar 1 billion in US Treasuries. The bank might require US dollars 25 million in cash or collateral to be posted as margin. (Using the Eurodollar deposits as the ‘margin’, suggests the collateral is typically between 2 and 5 per cent of notional amounts outstanding.)
The Global Financial Crisis and the subsequent regulations that were implemented in its aftermath brought to a halt the meteoric rise in OTC derivatives issued by investment banks. This in turn has stalled the growth in Eurodollar deposits. Moreover, since writing OTC derivatives was a high margin activity for investment banks, returns on invested capital generated by banks have collapsed.
The risk we worry about is that of one or more of the global banks are holding on to a ticking time bomb in their derivative books. For the central banks and regulators have stalled the growth of OTC derivatives but amounts outstanding remain in the vicinity of where they were just before the crisis.
For banks to start out performing broader indices, we think there needs to be either a flushing out of the risks in their derivative books — which no central bank or private sector bank would willingly allow — or a loosening of the regulations, which is simply another way to kick the can down the road. Neither choice is palatable, we suspect. Meaning that it will take a crisis that upends the current banking system and starting afresh to bring life back to the banking sector.
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.