2017 Boiling Down to these Two Things
It was not an especially significant week in the stock market, but it was quite an eventful week in the oil markets. We spend a lot of time in this week’s video addressing that subject. And in our written Dividend Café we not only cover the right posture to take towards the energy sector, but we address the entire lay of the land in 2017, a better understanding of liquidity, and all sorts of matters pertinent to investors. Let’s get right into it …
All oily about energy stocks
A drop to the $42/43 level in oil is a meaningful drop from the recent $52 level, and still notably higher than the Q1 2016 level of $26 wherein global demand fears took over. U.S. shale has become the marginal producer (thank God), and they have improved production efficiencies to the point that profitability can be achieved at much lower prices than previously thought possible. Supply has not come in from the OPEC freeze as much as anticipated as Nigeria and Libya were allowed to do as they pleased, U.S. shale producers found positive momentum, and too many speculators have recently run into overly ebullient long positions they had to unwind. The bottom line is that until and unless a drop in oil prices is driven by weakening demand, we see it as a fundamentally irrelevant event, and look to the impact it has in energy related stocks as a tremendous buying opportunity for patient and ambitious investors.
China finding some weak spots
We have written a lot in the last year or so of the various surprises and good fortunes that have served to soften China’s landing as their secular growth story decelerates. Indeed, while much of it may be a result of globally coordinated economic efforts, the reality is that a lot of the 2016 stock market turnaround was related to China’s performance economically. In recent weeks, though, some data points are causing us concern. Notably, their yield curve inverted earlier this month for the first time in four years (10-year yields were lower than 1-year bond yields). Monetary policy has somewhat tightened, which is probably a good thing, but it creates repercussions. Their central book is admirably pressuring their over-levered banks to de-lever, and it is having a ripple effect in the rate markets. This will very likely lower industrial production and construction in future months, and that is where the strength of their economy has come from. We don’t see this as a catastrophic, but certainly a headwind.
Three simple facts about 2017 investing so far
What has made money so far this year? Anything that doesn’t produce energy or depend on a steep yield curve. Put differently, the forces of a weak dollar and declining interest rates from 7 to 30 year maturities has made a lot of asset classes money, and damaged only a few asset classes. Only oil-related investments have not had attractive conditions in which to function. The weak dollar is supposed to be bullish for oil prices, but contrary factors have ruled out thus far. Should the yield curve steepen again in the second half of the year (the spread between short term rates and longer term rates expands), that would bode well for energy, financials, and probably not as well for high growth stocks. Our approach? Assume nothing about that which cannot be remotely forecasted with any semblance of accuracy – bond yield equilibrium is as elusive as any part of financial markets; being positioned in a more all-weather scenario may prove to be more beneficial. We would actually point to our own performance in 2017 as proof of this: The flattening yield curve has hurt financials, where we are heavy-weighted; struggling oil prices have hurt energy stocks, where we are heavy-weighted; and yet as the supplemental parts of our portfolio (emerging markets, asset managers, certain telecom and pharma names, etc.) have aided in offsetting those other more volatile parts of the portfolio.
What gives on MLP’s?
The oil and gas pipeline malaise of the last couple months has continued and this week was no exception. Fundamentally, there is a painful tension taking place wherein the whole complex suffers from bad sentiment around low oil prices, so the high volumes of production taking place that benefit MLP’s do not foster positive price momentum; and yet, if production declines to lift prices, the fundamentals worsen. Our take is that the quality operators with extraordinary financial metrics (great dividend coverage, healthy earnings-to-debt levels) will transcend the technical tensions of the current time, and be well-positioned for price growth when sentiment inevitably reverses.
What man’s illiquidity is another man’s risk premium
We close this week’s Dividend Cafe (below) with a quote on the subject of liquidity, one of the most misunderstood concepts in all of investing. We talk a lot about “risk premia,” for it really is the fundamental principle in all of investing (a premium offered on capital return in exchange for assumption of a certain risk). Speaking simplistically, stock investors take on market volatility risk and often single company risk. Bond investors take on inflation and interest rate risk. A very underrated source of risk premia is illiquidity risk – the premium we derive from the inconvenience of not being able to access the funds in a given investment. At times the risk premium around illiquidity is inadequate to fairly compensate an investor for that trade-off, but other times the premium is highly attractive.
Investors have different timelines, different objectives, and different cash flow schedules. But where circumstances fully allow for it, the illiquidity premium in private market investing can be very rewarding, and in an environment of close to 2% bond yields and 18x S&P multiples may be particularly enticing …
Productivity is the panacea its cracked up to be
If you read as much commentary on GDP growth and overall economic health as we do, you would be inundated with various perspectives on labor markets, demographics, and of course, productivity. It is not a fallacious approach to studying economic growth – the basic idea that an economy can grow without an increase in either labor or productivity of labor or both is absurd. Over a generational period of robust economic growth (roughly 1980-2000) we enjoyed the double whammy of increase labor participation (more people entering the work force, especially women, and more hours being worked; AND, more productivity from that labor force). Technological innovations certainly aided that productivity. So much of what we look at as investors now involves certain assumptions about economic growth, and labor markets have stagnated around low unemployment but low participation in the work force (the boom of women entering the work force is demographically largely complete, and a substantial amount of young people are not entering). Productivity has to pick up the slack for the declining assist the economy has gotten from the labor market.
This topic could very well bore our readers to tears, but it is not a small or insignificant topic. Ultra low interest rates have meant that the cost of capital for most companies is below their Return on Investment, and that has hampered productivity growth, no matter how counter-intuitive this may be. A friendlier tax and regulatory regime is also a no-brainer for improved productivity, but much has already been said about that. What we do know is that productivity must improve to see greater economic growth, and some of the traditional catalysts to such have run their course.
I’d rather listen to Wilson Phillips than the Phillips Curve
The Fed believes that it is a good thing to achieve 2% inflation, because it will mean the defeat of the deflationary forces that stirred them to monumental actions out of the Great Recession of 2008. And the Fed believes that they can/should raise rates in advance of this inflation actually happening, because they are “Phillips Curvers” through and through (for you who remember your college Econ course). The very low unemployment rate we have is supposed to spur on inflation (because a tight labor market is supposed to increase wages and then from higher wages we are supposed to see higher wages). So in the Fed’s calculus for monetary policy are actions taken in the belief that conditions will end up surfacing as a result of certain other conditions. Fair enough, but there is one problem: The “Phillips Curve” belief that unemployment and inflation are inversely correlated has been so discredited and disproven over the years, it is an absolute mystery to me that there are credible economists still following its fundamental tenet. We think it is important to understand what the Fed believes as a predicate to understanding what the Fed may do. Whether we agree or disagree, it helps inform our positioning around what “is”.
The best-laid plans of mice and the Fed
The Fed has said that they plan to begin letting $4 billion per month of Mortgage-Backed Securities and another $6 billion of Treasuries “run off” (mature, without proceeds being reinvested), beginning in the fourth quarter of this year. They anticipate this number rising over time, eventually becoming $20 billion per month of MBS and $30 billion per month of Treasuries. You can imagine that if their goal is to reduce their balance sheet by over $1 trillion, this will take a long, long time at this pace (over five years). Will their plans change should the slowdown of inflation expectations continue? Quite possibly. Are even these plans quite tame if the goal is to rid themselves of Mortgage bonds entirely? Yes, they are. But at least we see their present plan – slow, glacially slow, modest tightening – a move towards monetary normalization.
If only we could figure out what causes economic stagnation?
There is a dominant camp in economics today proclaiming the advent of “secular stagnation,” asking for us to prepare for a muted expectation in economic growth for the foreseeable future. No doubt countries like France and the United States show a trendline down (stagnating GDP growth) in economic movement, but other countries (the UK in particular) have seen a secular move up in economic growth over the last generation. In all countries we have studied, the operative variable was “government spending as a % of GDP.” In countries where that number is increasing, the rate of economic growth stagnates; it countries where that number declines (there are not many), the rate of economic growth elevates. This is what we call the “crowding out” factor – that government spending crowds out other more productive parts of the economy.
Chart of the Week
For all the talk about Trump, taxes, politics, Russia, ObamaCare, and anything else – herein lies so much of 2017’s real economic story so far; the flattening yield curve and change in expectation vs. November for expanding inflation.
Quote of the Week
Of the maxims of orthodox finance, none, surely, is more anti-social than the fetish of liquidity. It forgets that there is no such thing as liquidity of investment for the community as a whole.
– John Maynard Keynes
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We are looking forward to getting into “mid-year” synopses in another week here, as we stunningly approach the middle part of the year. It is crazy how quickly things go by. But in the meantime, we are carefully considering many portfolio adjustment possibilities, and look forward to continuing to work for our clients towards the most optimal trade-off of risk and reward. Have a wonderful weekend!
Originally published on Dividend Cafe.
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