Category: Economics

It might be a sign of the times that over the past half year or so I have been less focused as of late on my investment research looking at individual companies, and more about playing the role of “closet macroeconomist”, hence the focus of my posts being mostly about macroeconomics lately.

I am not intentionally trying to hide secrets (although there are a couple picks here and there in the non-oil and gas space that are still sitting on my research queue after passing my initial smell test) but in an environment where my baseline investment criteria is that it can earn 25% free cash flow to enterprise value, what’s the point in looking for other stocks?

The answer of course is there will be a time that fossil fuels will become politically correct once again (perhaps when all the lights and crypto farms shut off) and one will then have to dip into the watchlist bucket for other suitable investment candidates. That said, fossil fuels are still going very strong and hence why bother when the thesis I wrote back in 2020 (roughly summarized as being long anything ‘real’ and avoiding anything ‘financial’) is still very much intact?

The reason for the macro focus is simply because it is increasingly a dominant variable in today’s investing climate. To give an analogy, let’s say your choice was investing in established large cap gold miner X and gold miner Y. Ultimately you can talk about mine reserves, operating practices, all-in sustainable costs, capital structure, and on and on, but the dominant variable is much more simpler – the price of gold.

Likewise, the macro situation is creating a dominant variable environment where if you cannot get on board with the correct solution, it doesn’t matter what else you invest in – for instance, back in November 2021, it did not matter one bit which portfolio component of ARKK you invested in – you would have lost money no matter what. Perhaps the magnitude of loss would have been different had you chosen wisely, but it would have been a loss nonetheless.

The macro focus that requires meticulous attention is monetary policy and energy economics. Both right now are more dominant than ever as we are experiencing ‘the turn’ that has caught people flat-footed (including Covid, and the sudden realization of geopolitical instability in eastern Europe), coupled with an incredible amount of monetary mismanagement and dismissal of energy physics that has all translated into really terrible policy. Playbooks that worked in the past will not be working in the future.

One of these playbooks is a sacred tenant of portfolio management. It states that a correctly managed portfolio will have an equity and bond split, say 60/40. If you are young and want to take more risk, then 70/30 or even 80/20, but the point is there is some bond component. The notion is that when equities fall, bonds will rise, and if you maintain a consistent percentage, you will be able to rebalance and extract better value in the process.

We insert in the new macroeconomic reality where inflation is running hot and fast, and your bond portfolio is still trading at a negative real yield. This means that the bond component of the portfolio is losing purchasing power for the investor and only depends on other people purchasing bonds to keep its capital value in the event of an equity drawdown.

With the Bank of Canada, US Federal Reserve, and soon the EU engaging in quantitative tightening, coupled with increasing yields (that would also be impacted by QT in addition to inflation), bonds are going to be terrible investments if the next logical conclusion comes. What is this?

Continued monetary debasement. Amazingly despite everything, because the US dollar is the last one standing, it still wins by default. For now.

This brings up a rather interesting quandary for most institutional fund managers. You can’t hold cash (real negative yield, not to mention that you are hired as a portfolio manager to deploy cash and not stuff it in your mattress). You can’t hold bonds (take a look at the idiots that bought Austria’s 100 year bond with a 50bps coupon for twice par!). You can’t hold equities (take a look at the S&P, for example) although this is the least worst of the three options. Don’t even get me started on cryptocurrency as an asset class – although I do see that Luna is CAD$0.000101 a piece, so perhaps you want to buy one of these as an inflation hedge.

There is no escape at an institutional level. One workaround has been to shovel money into private assets and real estate and infrastructure, but these asset classes are very sensitive to rate increases although of course they do not mark them to market until it is too late. Private assets are a brilliant way to defer those losses, however!

Interest rates themselves are another matter. There has never been a point in history where we have seen such monetary manipulation to the point where real rates of interest have been driven this low without massive reverberations. The “consensus” scenario is that we’ll get a 50bps rate hike in July and then some more minor tightening before things ‘normalize’ and are back to normal.

But consider that your baseline input to the economy (energy) is at sky-high levels with no real material notions that more capacity is being brought online – what if this input to inflation keeps rising further? Everybody cites ‘demand destruction’, and indeed there will be a point where energy inputs will become so expensive that collectively we will be forced to stop using them, but until that point, we will see the trickle-down (or perhaps rain torrent) effect of these costs getting baked into everything we consume.

Likewise, salaries will be escalating, and inflation will start on its trajectory of a self-fulfilling prophecy – labour costs will rise because of inflation, and inflation will drive up the cost of labour supply. Already in British Columbia, we are seeing the seeds of this with the upcoming strike vote by the main BC Government Union – they are apparently miles apart from the government. This is one of many cases that will be resulting in significant wage increases going forward.

In a recent Bank of Canada speech (one day after the June 1st 50bps rate hike), we had the deputy governor talk about inflation. They’re now now talking about “avoiding entrenchment” of inflation. Note that derivatives of the word “entrench” is like the new “transitory”.

You don’t avoid entrenchment with small steps. You need shock and awe – something that goes beyond letting the market guess whether the next rate increase will be 50bps or 75bps. An example would be having an unplanned rate announcement with a 150bps increase “to get things back to the neutral rate”. The current short-term policy rate of 150bps is still at near-record lows (historically), and still below the ambient level the Bank of Canada had before Covid-19 (which was 175bps). The big mistake that people can make is this natural assumption of the “regression to the mean”, and currently that scenario right now is the bank will raise to 300bps and keep things there.

Consider the scenario where they will need to raise even further, to around 600 to 700bps to achieve the destruction of this “entrenchment”, and figure out the financial consequences. I am not saying this will happen, but it is definitely something that one should keep in their minds going forward – that inflation will be running away, just like how global warming activists claim that an increase in the Earth’s CO2 beyond a threshold point will cause a run-away greenhouse effect. Ask yourself what components of your portfolio get killed in a world where short-term rates are 700bps, we live in an inverted yield curve where the 5-year mortgage rate is 600bps and almost every asset out there is slashed in half. It isn’t pretty – practically everything other than cash loses in such a scenario (yes, including fossil fuels).

I am not entirely sure what is going to happen. Things are incredibly fluid right now, and I continue to remain very cautious. If there is any general prescription I could give to people, it is the following – if you’re leveraged, get at least flat.

The title of this post were the words used in the last sentence of the Bank of Canada’s interest rate announcement.

They did not surprise many with a 50bps increase (to a 1.50% target) although the yield curve regardless jumped up a little bit across the entire tenor.

Barring any catastrophic events, it is highly probable that July 13th will feature another 50bps rate increase. The yield curve continues to flatten.

Reading the BAX futures, over the next 12 months we have another anticipated 150bps or so of rate increases – instigated likely by ‘forcefully’. Today the 3-month banker’s acceptance rates is 195bps (98.05) and the December 2022 futures have it at 96.61, a 144bps difference. This very roughly corresponds to 3 50bps rate hikes (July 13, September 7, and October 26) before the Bank of Canada decides enough is enough.

After the July 13th rate hike is where things get interesting. There is this pervasive prediction of an inflationary course of mean reversion, under the theory that the inflation is caused by supply chain disruptions, Russia going to war and the like. Making this assumption can be hazardous to one’s financial health. For instance, if interest rates rise and inflation continues to remain elevated, the central bank will have no recourse other than to continue raising rates further (and possibly at a more rapid pace) to bat down inflation to a 2% target.

The temporal aspect of measuring inflation has an odd effect – for instance, in year 1 if the price of bread is 10 cents, and in year 2 the price is 20 cents, you’ve just experienced a 100% inflation. If the price of bread is 20.4 cents in year 3, you can declare victory as you’ve met your “2% target”, but the damage has already been done – that bread is going nowhere close to 10 cents no matter what your monetary policy is!

I suspect this is what will happen (get used to those high prices remaining… forever!), but there are some economic scenarios where we really start to see some very strange distortions, where despite high rates and monetary policy liquidity withdrawals we still will see rising long term interest rates. Right now the 5 year government bond yield is 289bps, but what if this goes to 400bps, 500bps or even 600bps? The implication of the real estate market seeing a 7% mortgage rate would completely crush the market and negative equity headlines would become rampant in the media. I’m not saying this will happen, but it is in the list of possibilities. After the summer of post-Covid fun is over with, there is going to be a sobering period which will be painful for many, even more so than what we are seeing today.

Be prepared to act more forcefully in the event that the landing is not so soft.

On April 27, 2022 the liability of the Bank of Canada (Members of Payments Canada) was $221 billion. On May 18th this was $193 billion and on May 25th, $189 billion.

Another $3 billion of government debt matures on June 1st and $270 million of mortgage bonds mid-month.

The US Federal Reserve’s incarnation of QT starts on June 1st.

I look at the carnage going over in technology (today’s slaughterhouse featured SNAP, down 43% on an earnings report I never bothered to read) and ask myself if I am vulnerable to any of this.

I am guessing all of the tech-driven spending, including advertising, is just falling off the proverbial cliff. Everybody’s starting to tighten.

Economically, experiential spending will dominate 2022 (hospitality/entertainment) entirely due to Covid, the deferment of this type of stuff for the past two years is causing this year’s demand.

Just get on Expedia and look up prices of car rentals and hotels, they are higher now than I have ever remembered them. Just as an example, looking here in the Vancouver area, your average 2.5 star hotel is going for roughly C$250/night plus taxes (domestically), and it isn’t even peak summer season yet. Car rentals are $100 a day, even for a compact vehicle.

The demand/supply dynamic is causing these huge price spikes. People have money to throw at ‘experiences’, while providers are short-staffed and facing the same increased costs for labour, supplies, food, etc., hence everything is going to be at a premium.

This goes on until people’s money runs out.

2023 will probably be a better time to take a vacation. After all these tourist agencies increase capacity they will discover that nobody’s coming next year.

The flip side is that discretionary goods in the second half of this year will go on a huge sale. Home renovation season this summer will be totally dead.

Portfolio-wise, the best thing for me to do at the moment is to just sit on my rear end and take no action. It helps when I do not own anything like SNAP, although I do note the closest thing I have to a technology holding is down about 30% peak to trough. I am not particularly concerned for this holding, which used to be my largest last year. What happened instead, however, is that fossil fuels started to take over the portfolio through appreciation.

I see people switch from large cap to small cap energy names, but I am quite happy with the mish-mash that I’ve selected from my DCOGI index. I have no desire to deal with the sub-50k boe/d sector.

As long as the commodity price environment continues, these companies will continue to make a fortune. It will get to the point where governments will try to steal more shareholder profits and when they start to make their cash grabs, it probably will signal a time to lighten.

In the meantime, I think the fundamental argument for oil and gas continues to be very good. Chronic under-investment since the 2014 boom for various reasons (economics, ESG, Covid) has significantly changed the demand/supply dynamics in a manner that will take years to rectify itself. Only now some people are dimly waking up to the possibility that “renewable energy” is not going to be replacing fossil fuels in any substantive amounts and that there is an insatiable and growing demand for energy. This energy is functionally a first claim on any input in society – even before the taxman, which is saying a lot. You only generate taxes through income or consumption and you don’t get either without energy!

The Federal Reserve and Bank of Canada’s desired effect right now is to deflate the asset markets, creating a ‘reverse wealth effect’ which will hopefully stamp out some amount of inflation.

We are already seeing this rush for liquidity. It’s been going on for months now, but it’s getting to the threshold where it is actually being noticed by most people as they check their brokerage account balances.

As funds start to face redemption orders as people continue to want liquidity and demand US dollars to pay off their debts, we see asset prices drop as a result, across the spectrum (especially “stablecoin” Luna holders!). Very little gets spared in these market situations.

Companies that have long track records of producing cash are taken from a higher multiple to a lower multiple. A company that was previously trading at a (truly!) stable 15 times earnings will be re-valued at 12 times – that’s a 20% haircut in price. You haven’t lost value in the company – it will still continue earning the amount of cash it has been earning, but instead your capitalized value of it has been re-rated so if you want the entire sum of those cash flows today you will be receiving less money.

Lower prices bring higher returns for reinvestment. That company previously trading at 15 times would give you a 6.67% return – today those same dollars would give you 8.33%. The company can then look at its ledger for reinvestment opportunities. In a perfect world, it will invest capital externally in those projects that can earn better than 8.33%, and if it can’t, it will buy back shares (or give it to shareholders as a dividend). Real world conditions are never as black and white or clean, and hence a market exists.

We look at another real-world situation where a company like (TSX: CNQ), at US$107/barrel oil, trades at 4.7 times free cash flow (21%). The opportunity for them is obvious – buy back their own shares – and in a day like today, they will easily be able to post a bunch of bids and get hit as their stock is down 3%. Will the market take them down 20% to 3.8x (27%)? If so, it will make their buyback program that much more accretive – if you take the assumption that this commodity price environment will continue.

This price environment cannot be and is not assumed to last by many, hence the very low price to cash flow multiple given to these companies. Indeed, a big destruction of demand would cause commodity prices to tumble and will correspondingly take down equities with it.

There is also a propensity by many to take gains on stocks trading at 52-week highs – either to cut down your percentage allocation (anybody with fossil fuels in their portfolio have most certainly seen them bloat to high percentages) or as a manner to ‘take chips off the table’, perhaps to invest in beaten-down technology companies.

These are financial considerations. You can make these transactions by clicking buttons in front of a computer. The real-world physical market is a different story.

With the physical commodity environment showing few signs of retreat (Russia’s oil and gas exports will surely drop in the upcoming months, and US strategic petroleum reserve releases do not appear to be making any dents on US crude inventory levels), for now, it appears that the physical environment is favourable for continued high prices. Coupled with massive amounts of cash flows being poured into share buybacks, should put a limit to the downside of the fossil fuel complex. Indeed, investors should be cheering on price drops as moments where more shares can be taken off the open market when the physical market is still showing great demand in relation to supply.

The physical environment of a relatively inelastic commodity is very telling. It is best illustrated with an analogy.

Let’s pretend that we have an island of 100 people, a food factory, and cash. Initially this island produces 110 meals per day of food, and this food is of the non-perishable variety, so you can store it somewhere for rainy days. Everybody is happy, the price of food is low, and everybody can go and watch Netflix since there is nothing else to spend your capital on in the island other than buying food and maintaining the food factory. Netflix makes a fortune since they can raise their prices continually, although there is a fraction of people that prefer to just watch the waves crash against the beach. However, over time, there is a belief out there that the food factory causes a slowdown of video streaming resolution, so many of the island residents manage to pass a policy framework that chokes maintenance investment in the food factory. Initially this doesn’t have much of an impact as food production went to 105 meals a day, but over the past few years, it has slipped below 90 meals, but there was a sufficient surplus to keep people fed.

Indeed, there was a disease that struck the island that caused residents to eat half as much as normal for many months, but they slowly managed to recover from this disease, and now are back to normal eating levels. The surplus of meals that was built up by the food factory that is now producing 80 meals a day was immense, but that surplus is now running low, and residents are starting to get fearful that they will not be able to purchase food much longer. The price of the meals slowly starts to climb as this awareness creeps in, and now that this surplus is approaching critical levels, prices on this inelastic good is very, very high and everybody on the island is now noticing the price of food, and talking about how we need to subsidize people to purchase food. There are also talks about how the food factory is unfairly engaging in price gouging, and how the factory should be “islandized” to ensure a fairer equitable distribution of food. Nowhere is it mentioned that capital should be invested into the food factory to increase its output – as this would slow down people’s video streaming resolution (no way you can watch those videos at 1080p when you’ve been watching it at 4K all your life!).

Hence the situation we are in today. It doesn’t end very well.