When the market punches you this badly, step back and think a bit

When you get into an investment, you should always have some sort of view and pathway that will guide you to your valuation assumptions.

Clearly in the past month, a commodity-heavy investor has gotten punched very hard in the face. What we have seen is a February/March 2020-style of trading in the commodity complex – indiscriminate amounts of selling. Back in February/March 2020, it took me about a month to get my act together during Covid (when I realized that people were truly losing their minds over it) before I was able to adapt.

This again is one of those situations that is forcing an adaptation.

The previous underlying thesis, at least as far as late 2020 went, was that there was a significant under-investment in capital expenditures (who wants to invest in oil fields when WTI is at -40?), coupled with demand increasing, especially as a function of money printing by governments.

The party went on for about 18 months and now we are on the flip side of the story, starting June 7th. The past has seen inflation, everybody is worried about it, but markets do not value they past – they value the future.

Today, the August crude oil contract is down 10%, and is down about 20% from its recent peak on June 14th, where it traded at US$121.

While letting the market be your sole guidance is always dangerous, when there is a significant breakage to expectations beyond white noise, one should always re-examine your thesis.

Now that the Federal Reserve and the Bank of Canada are drilling the stake deeper into the heart of the inflation zombie, we’re witnessing the results of the convulsions, and this guarantees in 2023 we will be seeing significantly lower levels of inflation.

I especially note what has happened to copper in the past month. If demand is high and world GDPs are high, then the price action we have seen makes no sense whatsoever in an inflationary and expansionary environment.

My crystal ball is telling me that it is probable the rest of the commodity market is going to experience what happened to the lumber industry, except in slower motion.

Dusting off my dis-inflationary playbook, it means that fixed income is your friend. In Canada, already we have seen the yield curve drop roughly 25bps across the board to roughly 300bps for long dated tenors. Fixed income markets have already priced in July 13th’s rate increase (I suspect it will be 50bps just given what’s going on in the markets), but in 2023 things will stabilize, if not head lower again when the economy starts to depress.

The playbook also suggests that the Canadian dollar will drop with a commodity price drop – perhaps on the way to 70 cents/USD??

What happened? I think there were a confluence of factors, but one obvious data point is that industrial production in Europe is going to get slaughtered due to high energy price inputs. This is going to significantly slow down consumption of industrial commodities. Given the energy starvation strategy that Russia is currently employing, this one is already in the bag.

There is also the issue of China, which has partially shut down its economy in the name of Zero Covid, but in reality there was probably a political component to this concerning the default of their major real estate developers (Evergrande and the others). The halting of construction in the country would have a massive impact on global demand, including that for metallurgical coal and copper.

Domestically, real estate construction is going to come to a halt – with 5yr fixed mortgage rates at 5% and construction financing costs equally high, this will continue to suppress activity in the sector.

It just doesn’t look good all around and the market has woken up to it.

The dis-inflationary playbook also suggests that entities with significant amounts of debt will struggle. Conversely, those that took the actions to right-size their balance sheets during the previous boom will not do as worse going forward. We’re now going to go back to the grind of low cost producers being able to out-last the transient high-cost players.

Economically this is not looking good – with margins compressing, the “E” in a typical P/E ratio will be dropping and this suggests further broad equity price compression. There will likely be some sharp rallies here and there, but the trend is now clearly down.