Category: Economics

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.

Globe and Mail: Interest rate trajectory will depend heavily on housing market, Bank of Canada deputy governor says

Bank of Canada: The perfect storm

Quite the difference!

Read the speech itself, and THEN the Globe and Mail article – by reading the news article first, you expose your brain to potentially getting swept away into some narrative which may or may not be a reflection of the intended communication.

Going to the speech:

As a result, we expect the recent increase in commodity prices to boost the level of business investment in Canada by less than half of what our models generally predict based on historical relationships.

All in all, the commodity price shock is expected to generate a modest positive impact on the growth outlook for Canada—smaller than we have seen in the past.

The Bank of Canada is surprised that commodity companies are contributing less in capital investment despite the price environment. I wonder why!

More importantly, a slowdown in growth does not have to mean high unemployment, which was the hallmark of the stagflation period of the 1970s. Right now, job vacancies are very high, which means employers are trying to hire still more workers from a declining pool of labour. By cooling overall demand, we can reduce the demand for labour and the degree of labour shortages in the economy. Employers could stop looking for new workers but keep the ones they have—with little impact on the unemployment rate. That is a scenario that delivers a soft landing.

Good luck! This is like the macroeconomic equivalent of trying to thread a needle while wearing heavy-duty construction gloves.

First, what might lead us to pause our policy rate increases as the rate enters our estimated range for neutral of 2% to 3%?

Now we will get to what caused the Globe and Mail headline to print:

Another factor that might lead us to pause is that many households have taken on more debt to get into the housing market. At the end of 2021, the household debt-to-income ratio was 186%, above the pre-pandemic level of 181%. And rising interest rates are designed to slow the economy by making borrowing more expensive. That tends to slow sectors like housing. But this slowing might be amplified this time around because highly indebted households will face high debt-servicing costs and will likely reduce household spending more than they would have otherwise. Our base-case scenario includes a slowdown in housing activity. But we could see a larger-than-expected slowdown due to higher indebtedness and unsustainably high housing prices.

There were a whole bunch of reasons rates will level off at the “neutral rate”, and reasons why rates would continue to rise, but the Globe and Mail cherry-picked this paragraph for their desired headline.

I’ll leave it up to you to digest the rest of it. The important signal of this speech is that we will see central banks give out this “Well, there is going to be a limit to rate hikes” mantra which will attempt to stop what has been a slow motion stock market crash in recent months. The Federal Reserve is likely to follow suit with their forward guidance (‘speeches’).

“What’s left of Canadian oil?” – March 29, 2020:

27-Mar-2020: TSX Oil Producers

Name	Root Ticker	MktCap 31-Jan-2020 ($M)	MktCap 27-Mar-2020 ($M)	Loss
Suncor Energy Inc.	SU	61,973	25,172	59.4%
Canadian Natural Resources Limited	CNQ	44,182	15,811	64.2%
Imperial Oil Limited	IMO	23,343	9,816	57.9%
Cenovus Energy Inc.	CVE	14,155	2,887	79.6%
Husky Energy Inc.	HSE	9,230	3,226	65.0%
Tourmaline Oil Corp.	TOU	3,617	2,116	41.5%
Vermilion Energy Inc.	VET	2,985	587	80.3%
ARC Resources Ltd.	ARX	2,486	1,335	46.3%
Crescent Point Energy Corp.	CPG	2,308	481	79.2%
Seven Generations Energy Ltd.	VII	2,222	488	78.0%
MEG Energy Corp.	MEG	2,024	365	82.0%
Whitecap Resources Inc.	WCP	1,974	387	80.4%

On January 31, 2020 there were 12 companies trading at a market cap of above $1 billion in the space (I removed the non-Canadian ones trading on the TSX). At the end of March 2022, there are about 28 of them.

CNQ is now the top dog with nearly a $100 billion market cap.

CVE bought HSE and is now sitting at around $50 billion.

How things have turned.

The even more interesting factoid is that when looking at CNQ’s quarterly earnings report, they have gone painfully out of their way to avoid telling people how much money they will be making.

The entire complex is trading as if the commodity environment is a ‘transient’ event. As a result, we are seeing very low free cash multiples to enterprise value.

This creates two avenues to earning a return.

One is that you sit on your rear end and wait for these firms to buy back their stock and/or give out dividends and you will earn a return the old-fashioned way – by buying and holding.

The other way is through speculation that the fossil fuel price environment is here to stay for a lot longer than most expect – you will then be a happy recipient of a multiple expansion.

Unlike a technology company stock that promises to pay out a decade from now after making copious amounts of expenditures, most (if not all) of the fossil fuel producers are generating cash today.

What is even more interesting is putting your mindset into the perspective of a pension fund manager.

You have a mandate to earn a return of, say, 7% for your clients. I’m ignoring the fact that CPI has skyrocketed this year (which would inevitably push up this number for the cost of living allowances that are typically given out with defined benefit plans, including the CPP).

On a day like today, both the overall equity market AND the long-term bond market have dropped. Normally there is an inverse correlation between the two assets. This correlation appears to be breaking.

If your pension plan is forbidden from investing in fossil fuels for whatever reasons, the pension managers have to achieve their returns in the rest of the market that does not include fossil fuels.

This is an exaggeration, but it is the financial equivalent of trying to earn a 7% net return on the residential condominium market in Toronto (or Vancouver, take your pick).

Formerly you were able to do it with leverage (e.g. take a 4% gross return and turn it into 7% by borrowing a bunch of money at 2%), but today, you can’t do this in a rising rate environment. Rising interest rates increase the cost of carrying debt, and hence why you are seeing liquidations.

Likewise in the equity and bond markets, the leverage trade appears to be unwinding. Central banks have given fair warning rates are increasing. Unlike in 2017 when rates rose again and inflation was very low, today’s environment has inflation figures that have not been seen since the early 80s.

This is a misleading article.

Globe and Mail article: Canadians are sitting on record amounts of cash – but nobody is sure what to do with the money

More than two years into the pandemic, Canadians’ wallets are still stuffed with cash.

There is currently about $113-billion worth of physical money in circulation in Canada, up by nearly 25 per cent from pre-pandemic levels. As a share of the overall economy, that’s more cash floating around than at any time since the early 1960s.

One problem with this article is that the amount of physical cash has continually been increasing since 1990, but during Covid-19, the rate of growth has accelerated, but not to a ridiculous degree:

This number has increased by around $25 billion during the Covid panic (measured from March 2020). A more “ambient” year-to-year change is around $7-8 billion in supply, which means that about $10 billion in cash was created as a result of the Covid panic. A large amount of money, yes, but nothing compared to the overall monetary base.

What the article should be focused on is the creation of credit during Covid-19, and you can view some evidence of this by examining the monetary aggregates as compiled by the Bank of Canada (I suggest looking at the unadjusted M2++). Needless to say, in our formerly zero-interest rate environment, credit creation has skyrocketed!