Macro-Economic Environment
While most market participants may not have known it, the world has been essentially short volatility across nearly every corner of the capital markets for more than a decade. This implicit bet, aided by the Fed and other Central Banks, was the driving force behind the period known as “The Great Moderation”. The events of the past several years, however, would indicate that investors would be better off positioning themselves to take advantage of greater volatility, (long optionality) as opposed to the status quo which has lasted since the GFC.
The breakout in rates and inflation from their extended multi-year down-move gives us some indication that volatility is now being introduced back into the mix. This is sometimes how risk gets resurrected. Remember that during the GFC, it took some time before risk permeated other parts of the capital markets. However, once it took hold, there was no sector of the market that was spared. We are not on the precipice of a GFC-type event at present, yet the level of complacency in markets outside of fixed income is puzzling to say the least and seriously concerning at best. While most geo-political events, such as the recent Hamas attack, produce short-term trading noise that evens out over time, today’s equity markets barely even take notice. We are not questioning the degree of panic that a given market should undergo because of an unforeseen event, but there should be at least some risk premium built in for such occurrences.
Complacency has a cost, and the cost of that complacency is the margin of safety that you hear spoken about so much. The more complacent you are, the more you try to avoid paying for the “what ifs”. The folks buying bonds in the summer of 2020 felt comfortable that 50 basis points was an adequate return for the risks they were assuming in buying a 10-year government bond. Whether they knew it or not, these buyers were making a significant bet on volatility. Those that understood, or were paying attention to, the convexity of bonds at those levels appreciated that the cost of ignoring the “what ifs” was immense.
The inability or unwillingness to appropriately price the “what ifs” is where we sit today. In our estimation, there are so many canaries in the coal mine at present our view is awash in yellow. The mispricing of second and third-level thinking is nothing new. It has mostly gained traction however as algos and speed of execution have taken hold.
The “what ifs” that we see today that are not being adequately accounted for include the following:
Politics: Next year 80% of the world's market cap, 60% of the world's GDP and 40% of the world’s population will be holding a leadership election. What if election posturing precipitated more spending rather than less, even with the existing debt overhang?
Credit: What if you had some problems in the non-bank credit markets, which metastasized into the broader banking system?
Inflation: What if the U.S. inflation rate bounced around in the 3-5% range rather than reverting back to a projected steady decline?
Geo-politics: What if the U.S. is forced to take a more active role in any of the existing conflicts or presumptive ones?
If investors start to address the “what ifs” then the next logical progression is “now what” or, more specifically, “how do I position for this potential scenario”. The answer is that investors should start to build portfolios that contain strategic commodities / hard assets.
Takeaway: Hard assets attributes: Unlevered; Possess inherent intrinsic value; Lie as potential targets in the race for strategic resources among competing countries; and Outperform during periods of high inflation.
Commodities/Energy
Strange times bring about strange markets, with “obvious” positioning amid a consensus mindset often wrong. Crude oil price expectations understandably skewed much higher in the immediate aftermath of the Hamas surprise attack in Israel. The combination of an already hawkish Israeli Prime Minister combined with the numbers of citizens killed or taken hostage has the ability to dramatically escalate this long-tenured conflict. This escalation may start to include many regional countries, several of which are significant oil and/or gas producers (Saudi/Iran). The intense retaliatory response involving the bombing of Gaza has led to massive protests worldwide, creating immense geopolitical unrest.
After an initial spike higher, WTI has cratered nearly 16% over the last two weeks. The evident potential for a widening of the war masked certain current realities that have now been exposed. Those realities include the unwinding of bullish speculative positions, seasonal softness, added Russian supplies hitting the market (see associated chart) and tepid demand reports out of China. Other factors include a U.S. economy that is now on recession watch as the 2’s/10’s Treasuries de-inversion trend remains formidable and recent employment numbers (including revisions) are suddenly exhibiting weakness.
The oil price decline is a welcome development for those looking to initiate positions in the sector. Expectedly, many bellwether O/G names have been excessively hit. Exxon and Chevron (recent acquirers of Pioneer and Hess, respectively) are trading at/near yearly lows. The margin of safety has been greatly enhanced, with both companies “printing cash” and generating a respectable dividend yield. There are many other examples in the sector with attractive risk/return dynamics. The potential of flaring Middle East tempers remains, and this broad based decline across the sector provides a (now) heavily discounted call option on oil exposure.
Canadian producers have also been in deep selloff mode for similar reasons with the added headwind of a significantly discounted (-$28/barrel) Western Canadian Select blend relative to WTI. This would be an opportune time to begin replacing sour SPR barrels at an attractive price-point. However, this is the same government, as Stanley Druckenmiller highlights, that passed on refinancing our massive deficits (through heavier long-dated issuance) when rates were effectively pegged at zero.
Takeaways: Global recessionary storm clouds appear to be forming across a number of global commodity markets. However, it is the U.S. equity markets that appear to be ignoring all warning signals. Rates coming off their recent highs doesn’t make passive investing in equity indices, which are trading at historically high earnings multiples, an allocation strategy we’d advocate.