Higher for longer, good news is bad news, etc.

I’ll just republish a CNBC article from mainstream media, noting this is the USA and not Canada we are talking about:

“Private sector companies added 497,000 jobs in June, more than double expectations, ADP says”

The sub-headline:
“Leisure and hospitality led with 232,000 new hires, followed by construction with 97,000, and trade, transportation and utilities at 90,000.”

ADP is a private sector payroll processor, so they have fairly good visibility on payroll data.

This much awaited recession is not yet happening, folks! It would be the oddest recession in economic history which still clearly had full employment.

As I wrote in yesterday’s article, “Essentially until we start seeing a gross contraction of employment demand, upward wage pressure should put a floor on inflation.”

So this “good news” (people working) is resulting in “bad news”, namely looking at the interest rate curve:

Canada, which is joined at the hip with the US in many things economically, also has a yield boost:

The far end of the yield curve (the 10 year point and beyond) is a core calculation for many asset management models. If that yield goes higher, more money gets allocated to fixed income than equities – for example, why bother buying the S&P 500 at 4% when you can buy its debt at 5%?

Here is the economic dynamic going on, based on this chart:

I don’t know how accurate this is, but essentially governments gave out a lot of surplus to consumers during Covid and they are still in the process of paring this surplus down. We are getting to the point where many people must pare back luxury expenditures (this would be leisure and hospitality spending, and those sectors have exhibited massive amounts of inflation – take a look at Expedia if you do not believe me) or earn more money (which they can through employment).

Either way, until we start getting reams of unemployment, those interest rates are going to stay higher for longer. I’d venture to say that broad market equity prices probably will peak out this summer. They are having difficulty competing against the returns in the bond market.

The ultimate silver lining, however, is that lower prices mean higher returns. If your companies are generating copious amounts of free cash flows, it doesn’t really matter. If, however, your companies are trading with a market value that is a very rosy projection of elevated future earnings, you may wish to check your risk.

The trick with obtaining these higher returns, however, is that you have the cash on hand to purchase at lower prices. If you’ve already spent the money, you’re out of luck.

The Bank of Canada will raise rates 0.25% to 5.00% on July 12th; the Federal Reserve will raise its funds rate from 5.00-5.25% to 5.25-5.50% on July 26th. There is also an outside chance that QT will be accelerated in an attempt to flatten the yield curve (selling long-term treasuries and buying the 2 to 9 year part of the curve). Buckle up!

Holding pattern

I’ve been on radio silence lately, as there has been little to update.

I will do a Late Night Finance quarterly review later this month, but putting a long story short, anybody that hasn’t invested in the top tier of indexes has likely underperformed such indices – with me no exception!

We are in a very strange market environment which is pricing huge multiples in the large capitalization companies – for instance, Apple is trading at 29 times next year’s projected earnings (TTM on September 2024). The equity at that rate of earnings, gives a total yield of 3.45% for an investor, while Apple’s unsecured debt, say their May 10, 2033 maturity is at a YTM of 4.35%.

It would be an interesting thought experiment whether Apple’s stock or its debt will give more of a total return over a decade. There is a lot of expectations baked into large cap equities.

Looking at something like NVidia and most “AI” related companies, the figures are even more expensive. Even if these stocks have a multiple compression of 50% (which would result in their share prices dropping by 50%) they look healthily valued. Higher prices means higher risk.

One conclusion I can make is that index investors probably will not perform nearly as well going forward. There’s probably some more room to go to give such investors a false sense of security, however.

While central banks are continuing to tighten and QT is progressing, there is still plenty of ample liquidity available for credit creation – it is simply more expensive. Companies borrowing money have to actually generate a return in order to justify the debt. It leads one to an ironic conclusion that investment leads will come from those companies that are taking out debt financing at current rates, opposed to ones forced to roll over debt.

While headline CPI figures continue to moderate, it is not evident that base economic factors (especially the cost and quality of labour) are at all easing. Essentially until we start seeing a gross contraction of employment demand, upward wage pressure should put a floor on inflation.

Also, as I alluded to in my previous post, the aggregate economic statistics also do not capture productivity very well.

There are other tail risks out there, namely social stability and the like. It is quite underestimated how close to a “flash point” things may be.

There’s a lot more swimming in my mind with respect to the future, but I will leave it here. Right now, I’m in a holding pattern.

Strange times

This is a post without much direction.

Canadian Macro

Perhaps the largest surprise to occur in the past two weeks was the Bank of Canada deciding to resume interest rate increases. I generally believe that this is an attempt to shake up complacency in the marketplace and that we are approaching the point of diminishing returns. By increasing future implied interest rate expectations, however, is in itself a form of interest rate increase. So we continue to have the triple barreled approach – actual rising interest rates, threatened future interest rates, and quantitative easing. Interest rates started rising on March 2, 2022 and we are about 15 months into the program. As capital hurdle rates have increased and projects that otherwise would have been initiated stall out, we’re probably going to start seeing this slowdown occur pretty soon.

The yield curve remains heavily inverted – right now you can get a 1yr GoC yield of 5.07%, while 10yr is 3.40%, a 167bps difference.

GST/HST inputs, from fiscal 2021-2022 to 2022-2023 (table 2), only rose 2.7% year-to-year, which is a negative real growth in GST-able consumption. This does not bode well overall.

I look at the inflation inputs and it seems intuitive that cost increases will continue to rise above the 2% benchmark – especially on shelter. The interest rate environment (in addition to other roadblocks) is seriously constraining supply, yet demand continues to remain sky-high (one of the effects of letting in a whole bunch of people into the country, including students, which massively raises rental rates in cities).

Inefficient spending

One of the problems of using GDP is that it doesn’t account for unproductive expenditures vs. productive expenditures. If you paid somebody a million dollars to move a pile of dirt from one location to another, and then back again, you would have a million dollars added to the GDP, but the wealth of the country has gone nowhere. That money could have been used for something more productive. If you get enough of this inefficient spending, it starts to show itself in other components of the economy – namely demand for goods/services that clearly are not being supplied because you’ve tasked too many people with moving piles of dirt from one location to another and back again. Those people could have been employed in another activity, say road building, which is a more skillful (and productive) use of moving dirt from one location to another.

It is pretty much the reason why much government spending is inefficient – it gets directed to segments of the economy which are for political purposes rather than productive purposes. Do this enough, and you eventually get inflationary effects in the things that people really need.

A lot of what we have seen over the past 15 years or so can likely be attributed to the cumulative effects of this. While governments are the chief culprit, the private sector as well has significant bouts of inefficient capital allocation (e.g. look at the value destruction in the cannabis sector, or most cryptocurrency ventures, etc.). The “slack” of the misdirection of resources has been exhausted after Covid, and the cumulative impact is truly obvious – a lot of people are going to suffer as a result, and collectively our standard of living will be declining.

Nifty 50 re-lived

The nifty 50 were the top 50 stocks in the US stock market in the 1970’s. Today, the top 10 stocks of the S&P 500 consist of about 30% of the index and many comments have been made about the effect of these stocks on the overall index. In particular, the rebound in technology stocks since November 2022 has caught many fund managers by surprise, and it is to the point where essentially if you did not own them (Facebook/Meta, Nvidia, etc.), most closet index fund managers would have badly underperformed. Perhaps it is sour grapes from somebody like myself (where I am barely treading water for the year), but this just does not look healthy.

Safe returns

Cash (various ETFs) return about 5.08% at the moment. For yield-based investors this is a very high hurdle. For example, looking at A&W Income Fund (TSX: AW.UN) with its stated yield of 5.3% – while you do get a degree of inflation protection, how much can burger prices rise before you start seeing volume slowdowns (and it is volume, not profitability that counts for these types of royalty companies)? Cash is out-competing much of the market right now. With every rise in the short-term interest rate, the differential widens.

Everybody looks at the charts of long-term treasury bonds in the early 1980’s and said to themselves “if only I had gone all-in on those 30-year government bonds yielding 15%, I would have made out like gangbusters”. This is almost the equivalent of saying your ideal timing into the stock market is February 2009, or March 23, 2020. The problem with such statements, other than they are entirely “hindsight is 20/20”, is that in order to get those 15% yields, such a bond needs to trade at 10%, 12%, 14%, etc., before reaching that 15% point. Valuations that would seem attractive and bought before that 15% yield point will have unrealized losses, sometimes significant, at the crescendo event. This is usually the point where most leveraged players are forced to be cashed out at the violent price action.

Parking cash is boring, and likely will result in the loss of purchasing power over periods of time (the CPI is a terrible barometer for ‘real’ consumer inflation), but better to lose 5% of purchasing power instead of 40% in a market crash!

Implied volatility

The so-called ‘fear gauge’ (the 1-month lookahead volatility of the S&P 500) is getting down to 2019 lows:

I don’t know what to make of this. Markets price surprises and probably the biggest surprise is a rip to the upside, despite all of the doom-and-gloom that the macro situation would otherwise suggest – perhaps interest rates are going to rise even further than most expect?

Either way, I’m not going to be a market hero. I remain very defensively postured and I do not feel like I have much of an edge at the moment. When you had everybody losing their heads over Covid three years ago there was a ripe moment where the reality vs. psychology mismatch created huge opportunities. Today, the normalization of this reality vs. psychology has created much more efficient market pricing. I can’t compete in this environment which feels like trading random noise. Maybe the AIs have whittled away the differential between reality and psychology – but they are only as good as the data that gets fed into them, and markets tend to exhibit random patterns of chaos now and then which will throw off the computers. So I wait.

If you ever wonder why I can’t work in an institutional environment, it is due to having some radical thoughts like the last paragraph.

An amusing moment – Reading the Bank of Canada financial statement

Reading the Bank of Canada’s 1st quarterly statement in 2023, the key table is:

Indeed, they booked a comprehensive income loss of $1.535 billion for the quarter, or about $40.13 per diluted Canadian.

The thought that immediately went into my mind was… “How come the Office of the Superintendent of Financial Institutions hasn’t taken over this bank yet?”

It’s exactly the same situation as Silicon Valley Bank or Signature Bankcorp – you have a balance sheet that is addled with low-coupon long-term government securities, coupled with paying out most of your balance sheet with a higher interest rate. At least with SIVB and SBNY you had a positive net interest margin, while the Bank of Canada’s is running at an annualized NEGATIVE 1.6%! That’s even after having a captive audience of over $110 billion of zero-yielding deposits (in the form of coloured polymer banknotes!).

That’s government I guess!

Rights of First Refusal coming in handy – Surmont Oil Sands

Suncor, April 27, 2023:

Suncor Energy (TSX: SU) (NYSE: SU) today announced that it has agreed to purchase TotalEnergies’ Canadian operations through the acquisition of TotalEnergies EP Canada Ltd., which holds a 31.23% working interest in the Fort Hills oil sands mining project (Fort Hills) and a 50% working interest in the Surmont in situ asset. This will add 135,000 barrels per day of net bitumen production capacity and 2.1 billion barrels of proved and probable reserves to Suncor’s oil sands portfolio. The acquisition is for cash consideration of $5.5 billion, with the potential for additional payments of up to an aggregate maximum of $600 million, conditional upon Western Canadian Select benchmark pricing and certain production targets. Subject to closing, the transaction will have an effective date of April 1, 2023.

Two assets were purchased. It wasn’t entirely clear what the price allocation between both assets were. Now we know:

31.23% Fort Hills – CAD$1.5 billion / $160 million contingent consideration
50% Surmont oil sands – CAD$4.0 billion / $440 million contingent consideration

Suncor purchased from Teck 21.3% (minus Total Energies’ right of first refusal component of 6.65%) for $1 billion. Suncor ended up with another 14.65% in total. The 31.23% consideration for $1.5 billion is roughly in-line with what Teck paid.

How did we figure this out the split between the two major assets?

May 26, 2023:

ConocoPhillips (NYSE: COP) today announced that it is exercising its preemption right to purchase the remaining 50% interest in Surmont from TotalEnergies EP Canada Ltd. for approximately $3 billion (CAD$4 billion), subject to customary adjustments, as well as contingent payments of up to approximately $325 million (CAD$440 million). ConocoPhillips currently holds a 50% interest as operator of Surmont and will own 100% upon closing. This transaction is subject to regulatory approvals and other customary closing conditions.

Here’s the kicker:

Based on $60 WTI, the transaction will add approximately $600 million of annual free cash flow in 2024, inclusive of approximately $100 million of annual capex for maintenance and pad development costs.

That’s US dollars – US$60 WTI = US$600 free cash flow, or about CAD$817 million. Suncor was paying about 5.4x free cash flow. Logically it is even better when WTI is greater than US$60! This should have been a pretty easy decision for ConocoPhillips to exercise the right of first refusal.

All of this was unfortunate because Total Energies was planning on doing a spinoff of these two assets and depending on valuation, I was planning on getting into this firesale. No longer!

It is no kidding that Suncor stock is down today – Surmont is 75,000 boe/d of low-cost production. Fort Hills has a rated capacity of 194,000 boe/d. While it is a nice consolation prize (especially as the entire operation is now consolidated in Suncor), the Surmont asset is something I’d like to get into at the price Suncor was paying!