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China and Energy

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As we slide through the summer doldrums, the news has slowed down to a mellow drumroll. That is, unless you count the events from June of 2016 and the manner in which White House has handled them. It appears that the Russian election scandal will continue to expand, albeit drip-by-drip, until we have a clearer picture from the Mueller investigation in a year or more. Until then, we continue to learn how this administration views others in the world who do not drink the Kool-Aid, with disdain along with a complete disregard for ethics.

On brighter topics, the news out of China yesterday is very encouraging. Their economy continues to grow at a steady pace of 6.9% per annum, consistent with the prior quarter. We know that the data coming from China is always suspect, but the trend is what matters the most. Given the issues we see with the U.S. economy (see our July 2017 Market Update), the ability for global economies to decouple from the U.S. is going to be the most important factor in managing investments through the next market cycle. China’s numbers are a good step in that direction and show that while the U.S. is important to China that importance has peaked.

A more troubling bit of news is the collapse of a $2 billion private equity fund run by EnerVest Ltd that was created to purchase oil and gas wells at the peak of oil prices in 2013. In typical private equity fashion the fund took on $1.3 billion in debt to “leverage” the returns of the fund. It turns out that the assets have lost so much value with the decline in oil and gas prices that the debt load is more than the value of the assets. This effectively wipes out the fund — the first total collapse of a large private equity fund ($1 billion or more), ever.

We saw something similar in the hedge fund world in July 2007. Back then a pair of hedge funds trading in sub-prime mortgage debt collapsed as defaults rose. At the time, it shook the markets as unprecedented but later to signal the beginning of a massive collapse across most hedge funds in the subprime area. Although private equity is far less risky and unlikely to spread beyond the energy market it does point to stresses in the current market conditions.

Time will tell, but it does highlight one market risk that continues to create turmoil throughout the various asset classes.
DBM

Bad Year.

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We are just eight trading days into 2016, and it is already one of the worst yearly performances in quite a while – down -7.5%.  The next two days will be critical, however, in determining if this is a trend or another speed bump in an already rocky market.

Using the S&P 500 as a gauge, we are down to levels that are consistent with last August and September, but just above those lows.  We are also at a level on the VIX – the indicator of future volatility – that is in line with September, when the market turned back around during the following four weeks.  It is NOT at the levels that we saw in August when there was real concern that the global markets were on the verge of collapse.

Put simply, this is not a market meltdown in the ways that we saw in 2008.  It is disconcerting, and on the heels of a very volatile and depressed 2015, it may be enough to push investors to be done with equities.  There are two core drivers of this market decline – China and Oil. China may very well be slowing down, but the reaction to these indications has been exacerbated by borrowed money and the interference of the Chinese government in the market. Similarly, oil prices will continue to drive many failures in the energy market, but the fundamentals shaping the low prices cannot continue for much longer.

We see some relief from these levels, but limited long-term upside until the economic picture improves.  The biggest unknown is corporate earnings announcements that will be coming out over the next few weeks.  Volatility will continue  as earnings surprises emerge, but the fundamentals are strong enough to dampen the market volatility in the medium term.

David

Market Update – July 2, 2015

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The first half of 2015 has been marked by some surprises, but at the end of June, the markets were in neutral, without any clear directional trend. While events such as the Fed move, oil price stabilization and disappointing economic indicators in the U.S. are all worth exploring, the Greeks are currently stealing the summer headlines. This update will address the current events in brief, while focusing on the prospects that we see for the second half of the year in what I’m calling the “durable economy.”

Thus far, the financial markets in the U.S. have generated negligible returns. Although there are some bright spots over the past six months, the collective S&P 500 is hovering around 2%, and the Barclays Aggregate Bond index remains slightly negative. Overseas markets are better in some areas, such as developed European markets, but with the prospect of a Greek exit from the euro, those returns just got halved for the year. The drag on overseas returns is China, which just entered a bear market this week after a series of missteps and miscues around sustained growth.

We don’t see this as all bad, and in fact, we are fairly optimistic about the prospects for the second half of the year. In a sense, the pause that the past six months have provided is beneficial to the markets over the long term. Keeping in mind that we’ve had a raging bull market for many years now, a breather in the climb gives the economy a chance to catch up to market expectations. In addition, we are also experiencing a significant shift in the manner in which the domestic economy generates growth.

I will address these factors in a longer Research Note this month, but for now, we appear to have shifted into a domestic economy that is resilient to a recession, yet unlikely to grow at the four to five percent pace that we have come to expect in past expansions. Two percent growth is all that the Fed projects for the next couple of years – not one of the most reliable predictors, but a good proxy. Given our heavy reliance on consumption for growth and a movement away from manufacturing, the modest expectation is reasonable. We appear to be shifting away from consumption as the primary driver of new growth and creeping into an innovation economy that would provide for a durable expansion over many years.

The downside to two percent growth is the threat of recession should there be any significant shock to the economy. Global events such as those in Greece, or conditions in Russia ranging from erratic military action to a decimated ruble, all have the ability to be that shock. Other possible shockwaves could emanate from increased occurrence of financial dislocation in markets driven by financialization (explained later), such as we experienced in the 2008 collapse. Similarly, more recent events, such as violent movements in the price of gold, the Swiss franc or oil could have an impact. But, we view the domestic economy at this time as stable enough to withstand most shocks.

With this in mind, we are looking at a variety of investment areas for the second half of the year. Energy, with the halving of oil prices last year, is one of the brightest spots in the durable growth scenario. Carbon-based sources and other alternative energy sources, plus the combination of an innovation economy with the dramatically lower energy prices this year, have stoked demand globally. That demand is translating into economic stability in some regions, and unexpected growth in others. We are incorporating the perspective of Mike Rothman at Cornerstone Analytics, which posits that demand for oil will outstrip supply by the end of 2015. While this prediction is counter to prevailing market sentiment, the growth in demand combined with a dramatic slow-down in drilling in the U.S. and declining well production in all other regions makes a strong case for this inversion later in the year.

Aside from energy, the disruption from Greece could present some interesting opportunities in Europe. Despite their market rally in the first quarter, the earnings multiples of European equities are still relatively modest, and the prices are even cheaper in dollar terms because of the devalued euro. If the region slips into another recession, then those valuations are too high; if the current situation resolves without significant economic damage to the broader continent, then the prospects are strong. Add to the picture the extensive exports by Europe to the U.S. and China — both of which are growing at a substantial clip on an absolute basis — and there is important upside for the European companies that operate globally.

 

Market Review

The context for the markets is fairly consistent with our discussion back in January: we’ve seen a relatively flat market with noted volatility around specific events.  The flat markets in the U.S. are striking — equities have struggled to improve their gains for the year, while bonds are showing losses.  Although some of the chronic underperforming markets had a strong start to 2015 (Europe in particular), the perpetual Greek crisis has already derailed many of those gains.

The chart below shows the three major asset classes in the US: the S&P 500 equities, Barclays Aggregate Bond Index, and the Deutsche Bank Commodities index, our rough benchmarks for most accounts.  They are not ideal reference points, but here they show you the general trend for the markets this year, keeping in mind that we’re seeing a very narrow trading range in all three asset classes.

Chart1Chart 1 – Market Total Return 2015. Source: Bloomberg

As you’ll see in this chart, U.S. stocks have had a year of relative quiet with gains of 1% – 4%.  Bonds, with the anxiety around Fed policy and interest rate movements later in the year, have moved only slightly.  The stock and bond indices combined, on a 60/40 basis that is typical of a diversified asset allocation model, yields a return this year of about 0.8%, depending on the week.

Also note the relatively tight range of trading on these assets – stocks have moved in a total range of 6% from high to low. Even commodities, a volatile asset class this year, has stayed within a 9% range.

Despite the perception of turmoil for the year, the volatility measures have been remarkably quiet. In fact, the equity markets have had their narrowest range of movement in the past two decades. According to Bloomberg, the range of movement from highest to lowest points for the year is just 6.5% a very modest move where the range is typically 10% – 40%. Add the VIX to the picture — the measure of expected future volatility in the S&P 500, which has not traded above 20 since January — and the realized and expected volatility is the lowest it has been in a very long time.

The key exception to this flat market with a narrow trading range is energy. Oil, in particular, has been all over the place. Starting with a 50% drop in crude prices going back to last fall, we saw a 30% jump in the early spring. The short-term impact of trading dynamics on oil prices far outweighs the impact of the supply and demand situation. Specifically, the amount of financial products that are traded daily on oil is roughly twenty-four times the actual demand for oil. This financialization is not new to the asset class. The phenomenon is a function of both growing derivative markets and the computerization of trading strategies, and drives many of the market dislocations across asset classes that we experience on an annual basis.

The take-away from financialization is the fragility of many markets, which are influenced by perceptions on any given trading day. Whether we are discussing gold, Swiss francs, corn, oil, or even Apple stock around a product release, the disconnect between fundamental value and trading price can be severe. Despite the anxiety that can arise around these fluctuations, financialization also creates enormous opportunity when actual value is separated from perception.

 

Economic Review

The factors that we continue to monitor for predictive market behavior are employment, GDP, and housing. We have gradually added energy to this discussion, given the volatility in the energy markets and the skewed dynamics it has created.

The U.S. economy is again expected to show slow growth in the past quarter, somewhere in the 1.8-2.0% per annum growth rates. Unemployment dropped again over the quarter, and the jobs creation picture is holding steady and promising. With close to 300,000 new jobs created every month, we are slowly mending the employment picture. But labor participation rates hide the broader story, as many folks simply are not participating in the trend. This causes a drag on domestic consumption, but also gives us tremendous room for growth before serious inflation is triggered.

Chart2Chart 2 – Labor Participation Rate in the U.S. 1945 – 2015. Source: Bloomberg

While our labor market has shown tremendous tightening in the past two years, the broader employment picture is masked by the historically low participation rate in the U.S. Driven by a combination of changing worked demographics (retiring boomers, for instance) and the perception of poor opportunities, we are at a level not seen since before women entered the labor force in earnest.

The part of the picture that I am most optimistic about is housing. New home construction (housing starts) have reached the one million annual level again – and are holding that level – after a dismal slowdown in the Great Recession. With a long-term average of roughly 1.5 million new homes per year, we have a long way to go. The competing factors here are housing stocks, which decline every year as homes are demolished, and the growing population, the impact of which has been partially offset as retirees team up with Millennials to consolidate households. Doing some simple economic math, an extra 500,000 new homes a year with the associated jobs, materials and durable goods purchases can add 1.0 – 1.5% to the annual GDP figure. In an economy still in need of consumption for growth, that could prove to be a tremendous stimulus for economic stability and market gains.

Chart3Chart 3 – Housing Starts 1970 – 2015. Source: Bloomberg

Housing starts hit epic lows after the Great Recession, bringing that sector of the consumption cycle to a virtual standstill. We are seeing significant gains in housing prices, and with eight years of contracting housing stock, we are poised to see a return to healthy housing starts. Between the jobs, materials and consumption that go into each new home, this recovery would add significantly to the GDP.

Turning to energy, U.S. “energy independence” threw a theoretical monkey wrench into the oil market. Lower prices have caused supply growth to decelerate with the prospect that OPEC might be fully tapped out. U.S. oil producers may be headed for annual declines in production by Q4 2015 due to a halving of capital expenditures and the high depletion rate of fracking wells. Yet demand growth seems to be picking up faster than economic surveys would suggest. Interestingly, this latter fact points to increasing economic activity in many emerging markets, even though traditional commodity prices have yet to show the correlated movement.

Overall, we are monitoring the energy picture extremely closely given the manner in which it can impact global demand and domestic inflation. Factors such as ISIS or the Iranian nuclear talks are just a few of the wildcards in this equation, with the ability to derail all of the models described above. It also continues to prove the case for alternative energy sources and inventive ways to use energy, stimulating innovation that will ultimately change the way our economy grows and how we live.

We are weighing all these factors as we rebalance our commodity exposure for the second half of the year. In recognition of the volatility in the commodities market driven by financialization, we are shifting to companies that profit from increasing demand as opposed to futures-based ETFs. The shift on specific commodities is also changing, with a heavier emphasis on energy and a movement away from metals and some agricultural commodities. On agriculture, our view is that the middle class growth will continue to drive food demand, but that going forward, we will invest in that area in a way that avoids the vagaries of temporary oversupply and political intervention.

 

Greece

The biggest risk as of this writing to the global growth scenario is Greece. We have never seen a country exit the euro, and the last time that a major borrower defaulted on their debts was the Lehman collapse of 2008. Back then, the global markets came to a freeze, with the prospect of a collapse in the financial system, as a trillion dollars of assets were wiped from the system and dozens of institutions teetered on the brink of failure.

Today, the situation is very different. Institutions have had years to assess the prospects of a Greek default, shoring up balance sheets and putting risk management tools into place. Most important, key institutions have trimmed their holdings of Greek sovereign debt to nominal levels. That said, someone is holding the debt and will suffer the consequences. In many cases, these are the hedge funds that once played this gambit with tremendous success. A Greek default would most certainly torpedo these funds, either through complete insolvency or a gradual rush of redemptions over the coming months.

The Greek financial system, however, would be in tatters. Aside from massive financial failures, the basic system of currency and payments will go into a tailspin. As one analyst put it, the Greek voter will be sorely disappointed when the supermarket is out of food and their ATM card no longer works. For these reasons, we don’t expect Greece to take themselves over the cliff. The political posturing is dangerous, yet the uncertainties of a break would do so much damage to their domestic situation that it would amount to national suicide.

 

Conclusion

“May you live in exciting times,” my Chinese cookie fortune recently told me. What we are seeing today is unprecedented, potentially dangerous, but rife with opportunity. The resilience of the capitalistic model is being tested, and at the same time, the benefits of technology are expanding in ways that are beyond comprehension. Many social issues need to be addressed now and for the long-term, but with the right perspective and an ability to see past the fears, we see this as a time to be thoughtful, cautious, and creative in our investment strategies.

 

Regards,

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David B. Matias

Managing Principal

The Supply Side of Oil

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After a brief rally at the end of January/beginning of February, oil prices are back at lows not seen since 2009 and the height of the Great Recession. With US production continuing to rise, now above 9 million barrels/day and storage volume at levels not seen in 80 years, the glut appears to continue.

The data behind the trend is quite interesting, however. Global production breaks down into three main groups: OPEC nations, Non-OPEC/Non-U.S., and the U.S. Of the three, only the U.S. is showing any sort of increase in production. OPEC was down slightly in February thanks to unrest in Libya and Iraq, and the Non-OPEC/Non-US figures are below 2014 levels. Note that the Saudi’s, with a third of OPEC production, is almost at full production and little room to compensate for further disruptions in the OPEC nations.

So the swing producer right now is the U.S.. Oil supply could change quickly, however, because of this. Active oil rigs in the U.S., the measure of future oil production in the US, is down by half in just a few months. With an inherent delay in production slowdown because of increased well efficiency, we won’t know the impact for many months.

And this does not take into account the impact of lower prices on demand.

It promises to be an interesting year for commodities. Oil prices are a wildly unpredictable dynamic… and one that will likely cause more disruptions in the financial markets this year.

 

David Matias

Managing Principal
Vodia Capital, LLC
 

Sources for data: Bloomberg.com and Cornerstone Analytics

Market Update: January 2015

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2014 presented a set of challenges that we have not seen in a long time. While the financial markets continue to have generally positive results, the global political situation is changing drastically. The continued dichotomy in financial returns — some markets up, others down – – is putting extreme stress on institutional money managers. In addition, the shifting fortunes of oil have changed global politics overnight, even as wealth inequality and social stresses continue to challenge our world in potentially disastrous ways.

The S&P 500 again finished the year with strong gains: 13.7% with dividends included. On top of 2013’s gains of twice that, one might think there should be little concern about markets and the ability to make money in them. Unfortunately, that is not the case. The developed markets in Europe and Asia had another year in which they vastly underperformed. In fact, both developed non-U.S. markets and emerging markets showed negative returns this year. Even within the U.S. market, performance among sectors and indices varied wildly, with the Dow lagging the S&P 500 by 4%.

Although the U.S. economy posted one of its best quarters for growth in Q3 with a 5% annual rate (the strongest in 11 years), most of the world’s major economies are shrinking, stagnant or slowing down dramatically. Europe is still in a recession; the threat of a broken Euro is being viewed as inevitable; and Japan continues to experience lost growth.

The 50% drop in oil prices over the past six months has created a geopolitical windfall for the U.S. that we could never have created on our own. Three of our major “adversaries” are reeling from the decline: half of Russia’s revenue comes from oil sales, Iran’s economy depends solely on oil, and 95% of Venezuela’s exports are oil. Each of those three countries are now forced to bargain with their U.S. surrogates as they face economic collapse. Even the renewal of diplomatic relations between the U.S. and Cuba has been connected to the oil situation, as Cuba faces the real prospect that Venezuela will stop subsidizing their economy.

Let’s take a look at how the three things I mention above – the financial picture, economic conditions, and political situations around the globe — played out in more detail:

 

Financial

This was a difficult year to make consistent returns, especially for institutional money managers who work with large pools of money and are solely assessed on their ability to “beat the market.” Equity mutual funds had their worst performance in 25 years, with 79% of U.S. stock funds failing to beat their market benchmark.[1] Ironically, the most common predictor of this trend is Apple stock: four out of five funds this year underweighted Apple stock anticipating the company to do poorly.[2] With Apple up 42% this year, that was a painful miscalculation. Those funds with market neutral or heavy Apple exposure were up 8% for the year. The rest were up just 6.2%.

Hedge fund returns are another set of indicators of a challenging year. These massive pools of capital are aimed at generating market-like returns with lower volatility. Their performance again has suffered with an average return of just 1.4%. As a result, the extreme volatility in December, with the market down 5% then up the same in just a few days, was blamed on these institutional managers trying to chase returns in the last month of the year. Bloomberg’s news service reported in December that hedge fund closings in 2014 were at the fastest pace since the collapse of 2008, all due to poor returns in the past few years.

Bonds, surprisingly, rallied another 6% this year, with the bulk of the gains being driven by long-term U.S. treasury bonds. While short-term bonds held mostly steady on rates, long-term interest rates on safe bonds plummeted from 4% to 2.8% on short supply and falling inflation expectations driving up long-maturity treasury prices by 24%. This flattening of the yield curve went against expectations, setting the stage for new challenges in 2015 as bond investors try to find yield while protecting against any unexpected movement in rates. With the Fed slated to raise short-term rates later this year, it promises to be a volatile asset class.

 

Global Asset Returns 2014

Chart 1: Returns for the major assets classes in 2014, with a wide disparity between sectors within the same asset classes. For comparison, the Dow 30 generated 10% while the Bloomberg Hedge Fund index was up 1.4%. Note that the bar for Energy was shortened for visual purposes – the actual bar would have gone down to the next paragraph.

Looking at market sectors, healthcare had one of its best years, with the sector up 25% and many of the major gains a result of frenetic merger and acquisition activity. Utilities, surprisingly, had a phenomenal year as well, with the fall in long-term interest rates making the dividends on these stocks extremely attractive. The rest of the sectors hovered around the market average, while key sectors like energy had a miserable year.

Investing overseas, however, was almost certain to generate losses this year. The major non-U.S. markets mostly suffered from very little growth on top of increasing volatility from political events. The biggest issue in global investing is the divergence in currency values. Specifically, the U.S. dollar is stronger than ever, battering the local currency price of any investment overseas. Although this trend may not persist, it would be a dangerous time to invest against it.

 

Economic

The economic situation in the U.S. seems to be improving and we have oil to thank for that. From an environmental perspective, I am loath to credit oil with anything good, but the economic reality is hard to avoid. For all its problems, fracking has done two remarkable things for our economy: it generated jobs and brought down the cost of energy through increased supply. As we outlined in our July 2014 update, the U.S. has increased production by roughly 5 million barrels per day, and in combination with improving consumption dynamics, has decreased our imports by 70% (depending on which source you look at).

The employment picture is the most critical aspect of our economy today. The labor participation rate – those who are employed or want to be employed – is the lowest it has been since the 1970s when women started to enter the workforce en masse. The factors I’ve heard are varied: changing demographics as baby boomers retire, hangover from the Great Recession, folks not being able to reenter the workforce and college debt overhang on the millennials.

But whatever the reason for the smaller workforce participation today, the number of jobs for those who are looking for work is back at pre-recession levels. What looked to be important wage rate increase earlier in the quarter fizzled out with a total annual gain below inflation. But with the addition of the actual savings from low gasoline prices, we see that disposable income suddenly increased for the first time in a decade.

The other aspects of the economy all continue to look encouraging: new housing starts are above one million per year, real estate prices are still climbing and back to pre-crisis levels in many communities, lending standards are relaxing for mortgages and equity lines, and disposable income is increasing with a lower cost of living from the decline in oil.

With all these tailwinds, the U.S. growth picture is the best in the world today, and in fact has once again passed China as the largest driver of growth dollars in the world. That is quite a change from just three years ago, when China took the definitive lead over the U.S. and Europe. The trick going forward, however, is that we won’t hit true long-term stability until global demand for our goods improves and there is a broader jobs base to drive consumption here at home.

The success of our overall economic situation is dimmed by a black cloud of wealth inequality in the U.S. and abroad. The disparity in wealth in the U.S. hasn’t been this great since the 1880s, and the gap continues to grow here and overseas. The challenges this presents are vast, from social unrest and nation-states at war, to an inability to support a growing consumption economy on the back of diminishing disposable income. Until this problem is addressed, the issues will grow and further threaten the financial markets.

 

 

Oil ProductionOil Res4

 

Chart 2: The disparity between oil producers and oil reserves is a startling insight into the longevity of the political and economic systems that depend on oil. Russia in particular is at risk within a generation, while the U.S. is highly dependent on new discoveries, without which we will deplete our reserves in five years.

Data: www.eia.gov, 2013 or 2014 used based on country.
 

Political

The foreign relations impact of the oil slump is startling. The significance of potentially bankrupting Putin and the Russian economy is not to be understated. As portrayed in my favorite Cold War movie, Three Days of the Condor with Robert Redford and Faye Dunaway, oil and energy security has dominated all aspects of our foreign policy for the past five decades. From the trillion dollars we spent over the last fifteen years to secure the Middle East (which arguably is in the throes of failure), to the massive drilling efforts within our own borders, oil overshadows all other policy matters.

The dynamics of oil are one of the most intricate issues I’ve had to grapple with. The chart above might shed some light on those dynamics. As you see, the top oil producers are Saudi Arabia, the U.S., and Russia. Each of those nations heavily depends on those oil revenues to keep their economy and society intact. The Saudis have used oil over the decades to keep a vastly underemployed and a religiously intolerant population at relative peace through expansive subsidies on everything from energy costs to quality of life. The Russians have taken the hundreds of billions in excess foreign currency to both enrich an elite class of oligarchs and to support regional conflict. And the U.S., as you know, has used cheap energy to drive a $16 trillion economy to generate the highest per-capita wealth in the world.

The fascinating part of this dynamic is the longevity of those oil sources. The Saudis can pump for decades, given the size of their reserves and health of the wells. The Russian wells on the other hand, have a short life-span. They have just a fraction of the Saudi’s reserves, and their well production is diminishing at an increasing pace. Russia has barely a decade to establish their place in a post-oil economy. It is a frightening prospect, given Putin’s quest for power and the prospect that his source of that power will disappear in his lifetime. He is not beyond actions and events that would bring us back to global conflict.

The Saudi/U.S. dynamic is even more intricate. According to popular thought, the Saudis are attempting to drive U.S. fracking out of business and regain their global dominance in oil. That narrative is fundamentally flawed, however. The U.S. must drill for an additional 1.7mm daily barrels of oil each year to compensate for the lost efficiency of their wells, with a cost of new production averaging $65-70/barrel.[3] The corollary is that fracking has an extremely short well-life, of just a few years, while the Saudis have a well life that spans generations.

The U.S. surge is a production surge, which is vastly different and has a finite impact. American energy independence is by no means assured, and in fact not likely to ever be complete. In 2012, the International Energy Agency reported that the US could become energy independent in the future, but that such a dramatic shift in production would be disastrous for greenhouse gas emissions. That fact was distorted in the American press to say that we will be energy independent, ignoring the obvious constraints associated with such a shift.

Oil is likely to cause significant upheaval and volatility in the financial markets in the coming year. The impact on debt markets is also non-trivial, as American energy producers face a cash flow crisis at these oil prices.

Change is a scary concept. It can be even more damaging to financial markets. Prosperity here will continue, but the durability of investments will be tested in this environment, and the volatility of the past will continue into the near future. Nevertheless, we at Vodia remain confident that our skillful, careful, and relatively conservative approach to wealth management and our vigilant eye on markets will steer us through rough waters.

 

Regards,

 

David B. Matias

Managing Principal

 

 

 

[1] WSJ, 27 December 2014, B1

[2] Bloomberg New Services, December 15, 2014,: “Shunning Apple Tops Long List of Bad Market Calls in 2014.”

[3] Two sources of data are The Economist (December 6th-12th, 2014) and the US Energy Information Administration, www.eia.gov.

Market Update – June 2011

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In a sign of our times, economies are slogging towards something yet-to-be-understood, revolts crop up around Facebook pages, and market pundits continue to drivel about a recovery “around the corner.”  Taking a step back from the daily static of mass media reporting, we are in the midst of a tectonic change in finance and economics that began a decade ago and signaled its presence in the collapse of 2008.

How we manage out of this change and ensuing crisis is yet to be seen, but the patterns are developing.  Unemployment, real estate and inflation are the factors we continue to focus on for the U.S.  Commodities, food and shifts in regional comparative advantages are the themes for our international investing.  Cash flow, value creation and sustainability are the core tenets for our investment strategy and will continue to be so for the coming months and years.

In this market update, we look at how these patterns have solidified in 2011 and the global factors we feel are most likely to influence our outlook.

Revolts in the Air – Still Looking for Progress

The news of global unrest in the Middle East has certainly been on the forefront of our minds in the past few days and weeks.  Peaceful protesters, tribal leaders, and indoctrinated dictators continue to vie for power throughout the region.  Domestic conflicts, like we are seeing in Yemen, have the potential to reverberate around the world as important oil powers like Saudi Arabia get involved.  All this has substantial impacts on the U.S.’s geopolitical hegemony.  The U.S. has appeared to play catch up to the political changes in the Middle East—changing policy as protesters gain power over dictators.  What is becoming clearer every day is that the U.S. will be challenged to maintain its position in terms of political or economic influence.  Democracy for all is a wonderful idea – but not a reality in a region that is still struggling with the basics of gender rights and religious freedoms.

The impact on the financial markets can be viewed through the lens of oil.  With the Middle East representing about 44% of current global production and 54% of worldwide reserves, any notable disruption to that region’s oil producing infrastructure will cause dramatic spikes in the cost of energy.  While short-term this drains current income for consumers and business, long-term it has the potential to create a nasty global recession.  Oil-producing countries have incentives to keep prices reasonable to ensure steady long-term demand.  Hence, OPEC’s intense interest in maintaining stable and predictable oil prices.  With Yemen on the southern border of Saudi Arabia and their close ties to Al Qaeda, many do not miss its importance in the global economic balance.

Any transition in Yemen’s government will set the tone for similar disruptions in the region.  Syria is to be closely followed for many of the same reasons – proximity to Israel and Iraq, close ties to Iran, and the potential for extreme violence.  The administration realizes the importance of these changes to our economic welfare.  The view of the U.S. as a fair negotiator may be critical to holding sway in key discussions between yet-to-be-known regional parties.  It is no surprise that Obama is attempting to take the initiative in the region with a hard line on Israeli-Palestinian peace talks: our ability to continue to shape the region is going to hinge on perception as much as reality. Time will reveal all as we closely watch this region.

U.S. Market Fundamentals

While the events in Yemen and the surrounding countries continue to evolve almost hourly, here in the U.S. the same themes from the past few months predominate— real estate, employment, and inflation.  The newest numbers point to more of the same in the labor markets, with limited job creation.

The most recent employment numbers remain just as distressing as ever.  The employment level, as opposed to the deeply methodologically flawed unemployment numbers, continues to stay at historically low levels—about 58%.  We haven’t seen numbers this low since the early 1980’s when the composition of the labor force was drastically different.  This is due to the increase in the number of women leaving the home sector to be “officially employed.”  So while the employment level is currently on par with the early 1980’s—a time of recession, it actually represents a worsened situation because the number of people seeking to be employed has grown in the past 30 years.

The employment level for the U.S. continues to remain at historically low levels dating back to a period in which women were a smaller component of the workforce.  The monthly movements up and down represent statistical noise in the overall picture.

Meanwhile, the outlook in real estate prices and future inflation continue to be troubling.  After a slight increase in 2010, real estate prices have declined again back to 2008 lows.  On a more local level Boston has faired better than average—we’re seeing prices around the 2004 level.  Atlanta, on the other hand, has taken a serious hit, losing more than a decade of appreciation and placing most mortgages under water.  As an asset that is illiquid and at the core of the real economy, these declines have wiped out trillions of family net worth.

The above chart shows the Case-Schiller composite Home Price Index going back to 2000, not seasonally adjusted.  While the drop-off in prices was severe, it has shown no signs of short-term improvement and in fact a bit of deterioration over the past few months.  Eight and one-half years of price appreciation has been eliminated from this collapse.

While some cities have fared better, Atlanta’s home prices (shown above) have suffered draconian effects from both the collapse and the ensuing foreclosures.  With prices retreating to levels not seen since the 1990s and falling a third from their highs, homeowners have lost a tremendous portion of their net worth and are underwater in most cases.

The slow real estate market continues to hamper the economic recovery on a host of levels.  On a macro level the perennial obstacle the housing market is facing is the foreclosure glut—banks are still dealing with a record number of homes that they have to move on a scale unimaginable before the crisis.  Homes remain vacant for months or even years in some cases, driving down the value of the surrounding homes.  With the banks relying heavily on valuation comparables and reluctant to lend in any situation that isn’t completely consistent with their stringent guidelines, the foreclosures enforce the cycle of declining values.

This all affects the labor markets when people have difficulty moving to identify or fill new jobs, causing extra friction that the economy doesn’t need.  In turn this trickles down to consumption spending.  The seemingly insignificant purchases that folks make when they move—throwing out old appliances in favor of newer versions—add up and create a real impact on the economy.  During the boom, this housing based consumption led to the massive trade imbalance with China and their multi-trillion U.S. dollar currency reserve.  Today it starves the economy for a source of growth.

Unfortunately we expect the situation in housing to remain fairly dismal until the banks get ahead of the foreclosure problem.  While it is conceivable that a recovery could occur without consistent real estate appreciation, we doubt that to be the case.  Look for this indicator to be closely watched in future updates as a gauge to domestic economic growth.

Turning to the treasury market we are getting an indication of the worries that surround the U.S. economy.  The interest rate on medium-term treasury bonds recently dipped below 3% in early June, a level not seen since last year.  From an investment standpoint the paltry returns on treasuries mean that holding a ten-year treasury to maturity will not keep pace with inflationary pressures, resulting in a negative real yield.

While changes in the equity markets often reflect the mood of investors, fluctuations in the returns on treasuries are more representative of educated institutional views on the economy.  Looking to Washington, these views seem validated as politicians continue to bicker across partisan lines as opposed to finding real solutions.  While the bickering over the debt ceiling is frivolous showmanship, and discounted as much by the market, a new round of quantitative easing would further devalue the dollar with the commensurate increase in inflation.

In terms of the U.S. equity markets the current volatility is in line with our expectations.  It can be easy to get caught in the day-to-day fluctuations (just watch CNBC for six minutes), especially when they seem to be predominantly negative, but it’s important to remember that on a year-to-date basis the market is up 1.5% (as of this writing).  The generally anemic growth in U.S. equities is to be expected considering the current economic outlook.

While the volatility in the U.S. equity markets appears daunting, it simply places us back at a 1.5% gain for the year during a period of strong economic uncertainty.  With a current price-to-earnings ratio on the SPX at 14x, and a future P/E of 12x, this level is consistent with corporate profit levels and expected growth.  While we don’t like to use these measures as a predictor of market movement, it does give us comfort in this level as a floor to short-term market volatility.

Because of the Fed’s loose monetary policies, we see inflation as a significant risk as the supply of dollars grows and excessive cheap money triggers future jumps in economic growth.  Core CPI, which excludes important variables like food and energy, remains almost insignificant at 1%.  Common sense, however, dictates that these are probably two of the most sensitive spending components for any inflation indicator.  Looking at the “All-Items” CPI data, which includes these numbers, inflation picks up a bit to 3%.  While this is notable, barring another recession we expect inflation to further rise to 5% or more in the near future.

This view is already being realized in the commodities markets.  While equities have declined by upwards of 7% in the past few weeks, commodity indices are flat or up.  Traditionally a soft economy drives down demand for commodities, but this disparity can be explained if we take a look at role of increased global demand.  We expect this development to continue, a view that is driven largely by changes in the global demographic.

Global Changes

To understand this trend we begin with the recent policy changes coming out of China.  It recently released the 12th Five-Year plan, instituting a dramatic change of policy from headline growth to the welfare of its citizens.  This is a much more realistic vision of where China needs to go if it wants to avoid a repeat of the trouble that’s been brewing in the Middle East.  Rising inequality has been a concern for China since it first began developing the urban coastline at the expense of the more rural inland population.  As a whole the country is still relatively underdeveloped, with only 50% urbanization and an average income that’s 1/10th of the United States.

The largest problem China will face in the coming years is a demographic shift as its one-child policy and declining mortality rates change the composition of the population.  With the labor force expected to peak in 2015, China faces the same situation as the U.S.—supporting a growing elderly population with a declining number of workers.  This means that increased health care and pension costs will eliminate the low wages that have effectively subsidized cheap products for Americans.   We will need a new source of cheap labor to keep the consumable economy ticking along.  Given our strong bias towards sustainability, I am intensely curious to see where the beast of cheap manufacturing goes next in search of higher corporate profits.

As China transitions to a consumption economy and as the size of their middle class grows, we expect resource use to become a major issue.  The continued urbanization and infrastructure needs will place demands on commodities for years to come.  However, China is at the forefront of renewable energy development, which is a promising sign.  All these changes coupled with the size and influence of China’s economy make it the global wildcard.  As China moves to secure its future and the necessary raw resources, we expect commodity prices to reflect these changes.

The Role of Resources in the Middle East

It is precisely the role of resources that has put the disruptions in Yemen on the front page of the news in the past few weeks.  The U.S. has been conflicted in its policy towards Middle Eastern nations like Yemen—preferring the dictator we know to potentially unfriendly democratically elected governments.  Yemen has historically been a haven for terrorists, and it is also located in a highly volatile area, just southwest of Saudi Arabia.  With 10% of global oil production, any disruption in Saudi supply will have far reaching effects for the United States.  Not just gasoline but also the transportation costs for virtual every item, from food to clothing, would increase if Saudi Arabia reduced its production.  Suffice to say the tenuous economic recovery would be wiped out.

A more immediate threat for Yemen is water supply.  With one of two major pipelines already destroyed by the fighting, the country’s capacity to pump water from the aquifers has been significantly reduced.  This may be a prelude to a truly global problem as populated areas all over the world deplete their water supplies.  The current disputes over oil will be dwarfed in comparison.

Summers in Greece

Needless to say, it will be an interesting summer.  Starting with 2007 and the sub-prime collapse, each summer has brought some form of volatility and a commensurate increase in the perception of risk.  Just like 2010, we are again faced with the prospect that Europe and the Euro are going to rain on everyone’s summer vacation.  While this is old news – Greece might default on their sovereign debt – it is news yet again.

The hope was that Europe’s various institutions, from public to private, would bail out Greece long enough for it to put austerity measures in place and regain its financial footing.  For a host of reasons, from cultural to political to simple realities, that is looking dubious at the moment.  The concern is simple – if Greece does not fully pay back their debt obligations then the value of similar debt from Spain, Portugal, Italy and Ireland will decline markedly in value.  If that occurs, banks with that exposure will take a large hit to their balance sheets and place their financial solvency into jeopardy.

This is not that different from the financial crisis of 2008, when real estate backed assets were the culprit and a host of banks needed temporary capital to ride through the losses.  The differences this time, however, are notable.  The amount of Greek debt is fairly limited, the exposures are mostly known and the banks are actually generating profits.  While I don’t want to dismiss the risks, the realities are likely to be far less draconian than the predictions.

Stepping back, while the U.S. indicators are weak and there are again riots in the streets of Europe, there is little new news.  What has changed, most likely, is that the “bull” market has run out of buyers and the reality of a paradigm shift in our economy is beginning to sink in.  We have a long haul ahead of us, and no quick fix is going to shorten that road.

All the best for an enjoyable summer.

Regards,

David B. Matias, CPA
Managing Principal

Unemployment for February – Good News, Bad News

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This morning, the government released statistics for the unemployment situation in February – a strong jobs growth of 192,000 new jobs across both the private sector and the public sector with a drop in the unemployment level to 8.9%  Yet, the market responded as if this was bad news, with a drop of 150 points on the Dow as of mid-afternoon.  Let us add a little color:

In fact, the jobs growth was exactly what economists had predicted while simultaneously predicting a steady unemployment figure.  The drop in the latter, in fact, is more driven by folks leaving the job market completely.  In effect, just giving up and either learning a new role in life or entering very early retirement  The jobs growth over the past few months is not enough to both repair the economy and accommodate folks just entering the work force for the first time.  We are slipping in this task – not gaining ground.

The second bit of news is the wage growth figure, which remained flat for February at $22.87/hour.  That is bad news, because of increases in the real costs of living.  While core inflation may be tame, things like oil and gasoline are going up quickly with the events in the Middle East.  This is very bad news – especially for folks on fixed wages or in retirement.  If there isn’t a correction in energy prices, the economy could be at risk of stalling.

So again we have to wait and see if there really is a strong recovery taking hold, if we’re just treading water, or if we are on the edge of another slide downwards.  It wouldn’t be a hard slide like 2008, but it would be enough to truly discourage folks.

Regards,

David B. Matias, CPA
Managing Principal