Macro-Economic Environment
Like many of those upon reaching a change in the calendar year, we at SOP have put together a list of our New Year’s resolutions. However, unlike many other lists that deal with diet and exercise, our list includes subjects we aspire to pay attention to when navigating markets in 2024.
Actively seek out those reliable sources whose opinions sit in direct opposition to our own: We recognize that it is only human nature to try and find opinions and positions that match one’s own. However, in today’s capital markets where groupthink (as evidenced by the domination in 2023 of 7 stocks in the S&P 500) is predominant, it is important that we constantly challenge our own natural biases.
Remember that causation and correlation are not synonymous: One of the biggest residual effects of the pandemic was the severing of long-standing economic relationships. This is evidenced by the erratic and unpredictability of global economic growth in 2022 and 2023. As such, newly established links in a post-pandemic world must be constantly scrutinized and questioned.
History is a guide, but only one guide: 2023 was the year which showed using historical predictors (even tried and true ones such as the yield curve) has its limitations. The old Mark Twain adage “History may not repeat itself, but often it rhymes”, may well be changed to “History may not repeat itself, but it only rhymes, so make sure you act accordingly.”
Sentiment drives the narrative, which drives behavior…often to the exclusion of fundamentals: Sentiment may often bleed into, and affect, “fundamentals”, described by the Theory of Reflexivity as practiced and espoused by George Soros. The FT just highlighted an AI-driven study involving hundreds of millions of articles stretching back over two centuries and it showed that economic sentiment drove growth, not the other way around. Interestingly, this sentiment has been declining for over 50 years, possibly indicating that as business cycles become less commonplace the widespread angst over the impending “next one” becomes even greater.
In the end, fundamentals may dominate, however in the short-to-medium term they are often overwhelmed by momentum: We may even go so far as to say that fundamentals are frequently meaningless in sectors/assets whose very existence depends on heavy speculation (i.e. Bitcoin). We must constantly remind ourselves that this environment only rewards a fundamentally sound position if it is also backed by price momentum.
Optimism and skepticism are not mutually exclusive: Taking a rational, dispassionate, and critical view of markets does not make us perennial pessimists. Warren Buffett often referred to his late partner Charlie Munger as the “abominable no man”. If you know, or have read, anything about Mr. Munger, these “no’s” were the result of a rigorous, analytical mind and not persistent cynicism.
Takeaways: SOP is constantly refining and questioning our approach and processes as market environments are always evolving and changing. This introspection is driven by our desire to maintain a degree of intellectual flexibility while also staying true to our core strategy.
Commodities/Energy
Oil Prices: Many energy-related troubles have intensified as we embark on a new year, with the exception of an oil price “fear premium”. Russian strikes on Ukraine have intensified amid wavering U.S. financial and weaponry support. Israeli attacks within Gaza are close to entering its fourth consecutive month, with the conflict widening to include Lebanon (Hezbollah). Relatedly, Red Sea traffic is down by about 35% with Iran-backed Houthi rebels attacking vessels (primarily containerships) linked to Israel. Finally, Iran and Syria are witnessing targeted attacks of Hamas/Hezbollah leadership within their borders. Given this laundry list of conflicts, why is crude oil struggling to hold mid-$70s prices (WTI), and where do prices go from here?
The first part of the answer to the aforementioned question relates to supply. In short, global supply has remained robust as U.S.-led sanctions either haven’t worked (Russia) or are being ignored (Iran + Venezuela). Furthermore, we feel as though the OPEC+ production cuts have crossed the threshold of their effectiveness. Additional OPEC+ cuts signal potential weakness in demand while bolstering spare capacity, which is reportedly ~6MM barrels/day with nearly all held by Saudi Arabia and UAE.
The non-enforcement of sanctions has resulted in Russian crude exports at an eight-month high and Iranian output of another 3.2MM barrels/day hitting the market. Venezuelan sanctions have been “eased” and are contributing another 800K+ barrels/day. Finally, U.S. production has surprised to the upside, outpacing anticipated 2023 growth (EIA).
Our take on the oil market in 2024 is that there is fundamental support, with the risk remaining skewed toward higher prices. Commodities, in general, perform positively in rate cutting environments, with interest rate futures markets forecasting no less than 100 bps worth of cuts through Sept. of this year. U.S. production growth is also forecast to slow markedly. Immense consolidation of smaller rivals by cash-flush larger upstream E&Ps reduces the need for a more rapid drilling pace. Declining Tier 1 drilling locations, high decline rates and lower recoveries are additional headwinds for the most prolific basins in the U.S.
We feel as though commodities have sniffed out a slowing U.S. economy and have largely led risk assets to re-price accordingly. Why? Because commodities supply/demand dynamics live in real-time, not on quarterly earnings calls that are often months out. The point is that if/when the U.S. dips into a recession, the air pocket for other assets (primarily those priced for perfection such as growth-heavy equities) will likely be much more severe. If a recession fails to arrive, commodities arguably have the most to gain through sustained higher economic activity combined with ongoing supply constraints (Suez/Panama Canal).
For crude specifically, global demand is expected to continue its march higher, rising by 1.4MM and 1.2MM barrels/day in 2024 and 2025, respectively (EIA). There are essentially no more tricks in the election year bag (SPR) to tap and global flows from everywhere, including sanctioned nations, are flowing unimpeded. There are a number of potentially disruptive situations that could push prices higher in rapid fashion, especially given heavy short interest (see chart below).
Takeaways: Risk/Reward appears to favor a selective allocation to commodities, especially given equity valuation levels and the ongoing debate surrounding inflation/rate direction. Much of what was expected in 2023 may come to fruition just a little late…in 2024, including the onset of a recession, value trumping growth, and the ramping up of IRA-funded infrastructure projects. What is a given, in our view, is an amplification of a number of commodity-impacted conflicts and the craziest (volatility-inducing) runup to a Presidential election ever witnessed.