The Trouble With Inflation

I’ve been following the inflation debate quite closely this year and thought I would pen my thoughts down. Friday’s CPI report showed that inflation in the US had moved up to 6.8% YoY, while core inflation (ex food and energy) was ~5%. These are the highest numbers since 1982 and 1991 respectively. Since April this year, YoY inflation has been >4% while core inflation has been >3%.

The US government and the Fed continue to insist that the drivers fueling inflation are ‘transitory’, including one-time base-effects (2020 base numbers ‘artificially’ low due to the economic impacts of COVID-19), and have kept fiscal and monetary policy in expansive mode.

Recently Jerome Powell admitted that the word ‘transitory’ is no longer appropriate when talking about inflation, but at the same time the Fed appears to be in no rush to increase interest rates. In fact, despite the stock market and the housing market being at or near all time highs, the Fed thinks the market still needs >$100bn of liquidity injection per month. The Fed will be buying $105bn of treasury and mortgage-backed securities in December (down from $120bn in November). Quantitative easing is expected to continue into mid-2022.

The current ‘real’ Fed Funds rate is now deeply negative, and the lowest in 40 years.

Treasury yields have also become deeply disconnected from the historical relationship to inflation (see regression below). This perhaps indicates that the gradual increase in indebtedness over the past ~50+ years has led us into a new paradigm where interest rates can’t be raised without severe financial and economic repercussions.

The Fed now faces a conundrum which many smart / prescient people saw coming many years ago: If the Fed keeps interest rates at near zero it risks inflation getting out of control and the stock market and housing bubbles to continue expanding to even more dangerous levels. On the other hand if the Fed starts hiking it risks a major economic correction given the high level of indebtedness in the economy and high duration in financial assets.

It’s important to remember that the financial market response to interest rate hikes is more sensitive to rate of change vs. the absolute level of interest rates. A 1% Fed Funds rate might seem low on an absolute level, but represents a 4x increase from current levels. To put this in perspective, it took the Fed 3 years (2015 to 2018) to gradually normalize rates from 0.25% to 2.5%, and even then the markets ‘cried uncle’ in December 2018 with a ~20% drop in the S&P500 and the Fed had to put its rate increases on hold.

Rising rates will also make financing the fiscal deficit and rising debt levels a much bigger problem. The US is currently running the largest fiscal deficit since the WWII period with a $3t+ deficit in 2020 and 2021 and a $1tr+ deficit projected for 2022:

Debt levels have also risen to record levels with US government debt to GDP at >120%, another post WWII record:

Fed interventions in the corporate credit markets have led to a surge in corporate debt levels, with corporations having increased their debt levels by ~$1.3tr since the start of the pandemic.

So in summary we have an economy where inflationary pressures are rising, but where the most important tool to fight this problem (interest rates) can’t be used due to the economy’s extreme sensitivity to changes in interest rates. The only way out is for inflation to come down on its own (i.e. hoping the ‘transitory’ mantra turns out to be true), but I don’t think this will be the case. Here is why.

I believe that inflation over the last few decades has been low primarily due to four key reasons (in no particular order):

1/ Low velocity of money circulation

2/ Globalization (China in particular) as a global deflationary force

3/ Bear market cycle in commodities resulting from over-investment in capex during the last cycle

4/ Technology

While I do believe that some of the drivers of inflation are transitory – for example pandemic induced supply chain issues and ‘revenge’ spending / ‘pent-up’ demand will eventually mean-revert – I also think we need to pay close attention to changes in the above four ‘structural’ factors which could impact price levels for years to come.

Let’s start with velocity of money. Rising asset prices combined with stagnant real wages and a lack of fiscal stimulus to supplement the Fed’s easy monetary policies have been major contributors to the low velocity of money and low inflation of the past decade. But in 2020 we had a big shift in this dynamic with the US government spending ~$4tr in fiscal stimulus to offset the impacts of COVID-19. While a lot of this stimulus money went towards filling cash flow gaps resulting from loss of employment income, a significant proportion went directly into people’s pockets in the form of savings and household de-leveraging.

Household debt servicing costs as a % of disposal income have taken a significant step lower thanks to low interest rates and manageable debt levels. Meanwhile personal income continues to grow at a healthy rate as a result of the stimulus checks, generous unemployment benefits as well as rising wages.

Combine this with increased retail participation in the stock market, crypto boom and rocketing home prices and you can see how, for the first time in a long time, the average US consumer feels empowered to spend more.

Change in household net worth from Q4 2011 to Q3 2021:

Since the Q1 2020 stock market crash, household net worth has sky rocketed and this is impacting not only personal spending, but also workers’ negotiating leverage with employers. After a very long time it feels as if the balance of power between capital and labor is shifting more towards labor with people quick to quit jobs (the ‘Great Resignation’) and increasingly reluctant to take on jobs that don’t pay the appropriate salary and benefits.

The National Federation of Independent Business (NFIB) conducts surveys of small businesses to assess labor demand, wage pressures etc. amongst other things. The results of a recent survey are quite illuminating as Nordea Bank summarized in the following four charts:

This data combined with the Biden administration’s plans for spending hundreds of billions on infrastructure and green energy suggests to me that the demand for labor and upward wage price pressures might be stickier vs. the past.

A recent survey by the University of Michigan shows that 1 in 5 Americans expect a wage increase of 10%+ next year. If workers are able to successfully secure such wage increases, expectations of wage increases could get embedded in their psychology leading to more consistent wage increases year after year, which eventually feeds into the prices of goods and services. This would lead to structural, multi-year upward pressures on inflation.

To summarize, the large financial asset bubble combined with significant changes to fiscal policy and labor markets could mean a structurally higher velocity of money as the lower and middle classes feel empowered to spend more and catalyze a wage-price feedback loop. This could make the current inflationary dynamic very different from the dynamic last decade.

Turning our attention to globalization, it’s no surprise to anyone following global markets that globalization is in retreat. Foreign trade as a % of global GDP peaked in 2008 at ~61% and recently took a sharp turn lower catalyzed by the US-China trade war of 2019 and further exacerbated by COVID-19 which exposed supply chain dependencies and increased calls for more ‘in-sourcing’.

Take semiconductors as an example. Currently the majority of semi conductor fabrication happens in Asia with Taiwan and Korea having a large share. US semiconductor companies have chosen to go ‘fabless’ and outsource manufacturing to companies like Samsung and Taiwan Semiconductor Manufacturing (TSM). This poses risks in the event of a US-China conflict (given China’s close proximity to these critical manufacturing facilities). Nvidia (NVDA), for example, is a fabless semiconductor company that is reliant on TSM to make their chips.

Recently Intel has agreed to invest in the development of new fabs and has been pushing the US government to provide subsidies to chip manufacturers who choose to do so domestically. Moving semiconductor manufacturing back to the US will increase resilience, but also increase price pressures. Facilities like the proposed Intel fab cost hundreds of billions of dollar to develop and require highly skilled labor to build and operate which will cost more in the US than in Asia. There are many such examples under Biden’s ‘Buy American’ and ‘Make It In America’ mantras, but they will only be accomplished at the cost of higher end-prices to the consumer.

Despite the political pressures to in-source, a lot of manufacturing will continue to be outsourced to places like China. But even there, important demographic and socio-economic changes are threatening the labor cost advantages that once acted as a strong deflationary force.

As China lifted hundreds of millions of people out of poverty over the last couple of decades, its population started demanding more than just basic sustenance. Wages in China are on the rise and workers are demanding more pay, more benefits, better workplace environments, less pollution etc. All of these are exerting upward pressures on the cost of production in China and are likely to continue as China pursues its ambitions to become a consumption-driven economy vs. being reliant on investments, manufacturing and exports. On top of this, China’s birth control policies have led to a significant demographic headwind that the government is trying to reverse but will likely take decades to accomplish.

This year China allowed couples to have three children, up from the two child policy initiated in 2015. However China’s birth rates have been stubbornly low as couples have found it difficult to afford raising a family with rising property prices, cost of living and environmental issues. This is the impetus behind China’s recent focus on the idea of ‘common prosperity’; the idea that corporate wealth should be redistributed and some essential services like online learning should no longer be under a ‘for-profit’ model. Environmental and worker safety issues have also been on top of mind. Some would argue that the recent Evergrande saga signals the country’s willingness to let the real estate bubble ‘pop’, trading short term financial / economic pain for longer term stability and affordability in the real estate markets.

Keeping all of this in mind, it’s hard to argue that China will continue to be a source of plentiful cheap labor for the world to fulfill its manufacturing needs. There are other countries like Mexico or India that might work as alternatives, but it’ll take many years for these countries to develop the necessary infrastructure and train their labor force to displace Chinese manufacturing prowess in any meaningful way.

I won’t say much about energy prices here since most of the content on this blog has been focused on the impending energy bull market. But I will share a chart and a graphic that makes it clear how important oil is to the inflation puzzle. This chart from Lyn Alden (lynalden.com) shows how inflationary periods are usually accompanied by oil bull markets:

And this graphic from Visual Capitalists illustrates why this is the case. While most people think of oil as the fuel that powers cars, jets and ships, the bottom part of the graphic makes one realize that oil touches pretty much every part of our lives. Whether its asphalt in road, plastics, paint, synthetics, rubber.. you name it – it all needs oil to be produced. Higher oil prices therefore flow through into the price of pretty much everything you pick from the shelves.

While I believe technology will have a role to play in dampening the impacts of some of these factors – given the nature of inflation expectations, demographics, geopolitical shifts and commodity cycles, I doubt that the current progress in software, AI and digitization as a whole will be enough to offset structural inflationary pressures. I remember some tech folks telling me several years ago that oil prices were doomed because AI-based software would make oil exploration and extraction significantly easier and cheaper going forward. However, recent developments in the US Shale sector demonstrate that software can’t overcome the limitations of geology and the capital intensive nature of finite resource extraction. Progress in the world of bits and bytes doesn’t always translate into the world of atoms and molecules. And the latter is what the goods we consume are made up of.

Conclusion

The Fed is stuck between a rock and a hard place. If it continues its current policy, it risks losing credibility and hurting the well being of ordinary people as inflation eats away their spending power. Also, given the structural nature of inflationary pressures as described above, the Fed would risk getting inflation expectations out of control. On the other hand, raising rates will almost certainly lead to volatility in financial assets, credit contraction and potentially a recession. Given the high levels of debt in the system, there is a possibility that something could ‘break’, leading to systemic risks. As of this writing, a number of interest rate sensitive growth stocks have dropped 50%+ below their recent highs. While the broader indices have been stable, there is a lot of financial pain underneath as pretty much the entire basket of non-profitable growth stocks has been re-rated lower. If the Fed chooses to accelerate its tapering and hiking timeline, there will be a lot more pain to come. Ultimately if I’m right about the structural nature of inflationary pressures, the pain will be a lot deeper and unavoidable.

Going Down The Crypto Rabbithole

I’ve historically been dismissive regarding cryptocurrencies, especially given the numerous signs of speculative mania and colorful personalities involved. But recently, I’ve been starting to develop conviction that there is more at play here than a simple ‘tulip mania’ type phenomenon. The problem for investors is sifting the signal from the noise. And there is a LOT of noise. Whether it’s Elon Musk’s tweets on the topic, stories of teenage crypto millionaires, the sometimes gut-wrenching volatility in the prices of the assets, or the pace of new technologies and applications coming to market (e.g. the recent NFT craze)- it’s hard to figure out what’s really going on. A lot of conservative investors have decided to dismiss the entire sector as some kind of fad or bubble due to the abundance of speculative activity. Others have decided it’s too much work to sift the signal from the noise and have put crypto in the ‘too hard pile’. This could be a mistake.

As of this writing, the total crypto market cap is ~$2.7tr. Bitcoin alone is a >$1tr asset with backing from numerous large institutions (BlackRock for e.g.) and is becoming increasingly accepted as a superior store of value relative to traditional alternatives such as precious metals. As much as the ‘crypto is a bubble’ crowd would hate to admit, it seems increasingly likely that Bitcoin is here to stay. And there is more to the story than just Bitcoin. Tokens like Ethereum are opening up the potential for a whole new way of organizing and structuring the internet, the economy and institutions in a way that could overcome many of the limitations and failures of our current world order.

Decentralization

The technology behind blockchain and how it works is beyond the scope of this blog post, and there are countless resources on the internet that help explain the fundamentals (this is a great resource to get started). For this piece I’m going to keep the discussion focused on the problems crypto is trying to solve, how it uniquely solves them and some key topics to research before getting involved in the space as an investor.

The way I think about blockchain and cryptocurrencies (including tokens and other crypto assets… the distinction is important but doesn’t matter for this discussion) is that they solve a fundamental problem with how we have structured modern society, the internet and the economy: the properties of trust and power have become concentrated in the hands of a few, preventing frictionless collaboration and creating increased fragility and opportunities for the abuse of power; this is also exacerbating wealth inequality as the members in various centralized ecosystems are not getting the fair share of the value they add to these ecosystems.

For example, the largest technology companies are starting to look like monopolistic toll roads for economic activity. Want to market your business and sell products online? You have to pay a toll to Facebook, Google, Amazon, Shopify etc. Want to develop an app and sell it to millions of users? You have to pay a toll to the Apple App Store. Want to collaborate in a work environment? You have to pay a toll to Microsoft Teams or Slack.

This isn’t a problem limited to technology. Other large institutions like banks, insurance companies etc. have been generating toll-like revenue from our economic activities for much longer than Big Tech. Government institutions also tax our day to day activities in exchange for the promise of public goods and services, but often fail to to address burning structural problems like inequality and climate change that require short-term pain (which often reduces the government’s chances of re-election) in exchange for long-term results.

At this point you’re probably thinking I’m going to paint some kind of utopian picture of a world built on the blockchain, but that’s not where I’m going with this. Blockchain technology has its limitations, and it certainly isn’t a solution to all the problems I just listed. But it does address the root of where these problems originate: it’s hard to establish trust in society in the absence of centralized power and institutions. In doing so it offers a new tool kit to problem solvers to work on addressing these issues in ways that weren’t possible before.

Why do we pay a toll to Facebook? Because Facebook ensures that we can trust people are actually who they say they are in their online profiles (well not always… but they try). Facebook manages a centralized database of user identities which allows us to socialize online. Why do we buy things on Amazon? Because buying them directly from someone online exposes us to the threat of counterparty credit risk and counterfeits as well as the issue of figuring out transportation logistics. Amazon allows us to trust online counterparties and offers a streamlined online shopping experience. Why do we pay a toll to banks, law firms and insurance companies for day-to-day transactions? Because these institutions have the infrastructure and checks and balances in place to ensure the identity of various counterparties in a transaction and the validity of economic transactions and contracts. Why do we elect politicians to make decisions for us? Because we can’t trust each other to collaborate and work in the absence of a centralized authority in a way that advances broader society’s well being rather than just looking out for ourselves.

Trust is essential for capitalism and democracy to work, and while institutions have become ever more efficient at providing it, they have become dangerously powerful and are extracting an ever greater cost from society in exchange for offering it.

Double Spending Problem

Let’s bring this down to earth. A simple example of the ‘trust’ problem is sending money to someone over the internet. Because software has zero marginal cost of distribution, if I send a piece of code to someone that represents $1, it’s effortless for me to copy and paste that code and send it to someone else as well. That way I’ve spent $1, twice – the classic double spending problem. To avoid this problem we use intermediaries like banks and payments software to transfer money online in exchange for a fee.

This problem exists because of the fundamental nature of how software and computers today are architected: computers are controlled by humans, and humans can often alter computer programs with minimal effort. This means its hard to establish trust in a piece of code.

Chris Dixon of Andreesen Horowitz does a great job of explaining succinctly how blockhains solve this problem:

“I like to say that blockchains are computers that can make commitments. Traditional computers are ultimately controlled by people, either directly in the case of personal computers or indirectly through organizations. Blockchains invert this power relationship, putting the code in charge. The programming logic behind it is more complicated than we need to get into, but the end result of it is that blockchains, once established, are resilient to human interventions

As a result, a properly designed blockchain provides strong guarantees that the code it runs will continue to operate as designed. For the first time, a computer system can be truly autonomous: self-governed, by its own code, instead of by people. Autonomous computers can be relied on and trusted in ways that human-governed computers can’t.“

In the case of the double spending problem, the blockchain solution is to create a commitment to scarcity. Every Bitcoin has a unique identifier, and each transaction on the Bitcoin blockchain is verified and recorded into a database that can never be altered by anyone. The responsibility for security and preservation of this architecture is distributed throughout the network as opposed to one central authority. Through this genius architecture, Satoshi Nakamoto created digital scarcity and trust without the need for a centralized institution.

Based on how the Bitcoin algorithms are written, only 21mm Bitcoins will ever exist. And no centralized authority has the power to alter that. This means that Bitcoin is an excellent store of value for someone looking to hedge against the risk of monetary debasement. This is similar to gold which has a finite supply and a very high and well-defined stock-to-flow ratio (the amount of gold mined every year is fairly stable and a very small percentage of the overall stock of gold). But in some ways Bitcoin is even better than gold: 1/ it’s annual supply is completely fixed and independent of the price of Bitcoin (gold supply can and often does fluctuate with gold price) 2/ since gold is a physical commodity it can easily be mixed with impurities and sold fraudulently to unsuspecting buyers, whereas Bitcoin and the underlying blockchain can never be altered (except with an impractical/unfeasible amount of computing power) as this is the fundamental principle behind their design.

Moving Beyond Store Of Value

In a way digital trust is even stronger than the types of trust we place in physical processes such as signing a document, or visually inspecting a piece of art. These physical processes often involve human intervention and judgement whereas the blockchain relies on a much stronger security protocol rooted in cryptography.

Let’s extend this concept of digital trust beyond monetary ‘store of value’. Imagine if you could trust someone’s identity online without a centralized database and use this as the foundation of different types of online interactions (social, ecommerce/payments, collaboration etc.). That would allow us to move beyond the limitations and value extraction of Big Tech to a completely new type of internet (commonly referred to as Web 3.0) which is far more open, collaborative and offers better incentives to developers and programmers to develop the best technologies.

Similarly imagine everyday economic transactions happening on the blockchain – let’s take the example of real estate where there are multiple layers of trust required all the way from proof of ownership to proof of funds and identity. A decentralized repository of identities, combined with decentralized finance (DeFi) and a blockchain to record real estate transactions would mean a lot less involvement by banks and real estate lawyers to securely close real estate transactions. The concept of title insurance would disappear.

Billions of dollars are spent every year on copyrights / licensing. But with blockchains, verifying authenticity of content can be made a lot simpler and cheaper. When you buy a painting you usually need some kind of physical inspection or appraisal to ensure what you’re buying is original. But even then there is room for error as no inspection is 100% fool proof which is why art fraud is still fairly common. With Non Fungible Tokens (NFTs), every piece of digital art is associated with a token on the blockchain which acts as a certificate of authenticity. When you buy this piece of digital art, what you’re actually buying is the underlying token (which cannot be replicated) and the transaction gets added on the blockchain. If someone now tries to sell a fake copy of this piece of art, the fraud will be easy to detect as this individual won’t be able to present the original token as proof of authenticity.

Finally, let’s think about collective action, government and institutions. Today, we depend on governments to provide us with public goods and services because we have few good ways to trust each other and collaborate on such projects. We also rely on corporations to accumulate capital, labor and formulate and enforce the rules that allow us to work together to achieve certain economic objectives. However these centralized forms of resource allocation leave us exposed to abuses of power. Governments promise one thing and often deliver another, companies often change their original agreements with workers for the benefit of shareholders.

Using blockchain technology, these activities can be organized under Decentralized Autonomous Organizations (DAOs). DAOs are represented by rules encoded as a transparent computer program on the blockchain. Since these rules are agreed upon by the members of the DAO and cannot be changed by any one individual, DAOs do not require traditional governance structures such as boards of directors and executive officers. This ensures that the organization operates on a truly neutral and democratic basis. Every member of the organization has a “voice” through community governance and can choose to exit if the organization no longer meets their goals and principles by either leaving the network or selling their coins / tokens to someone else. DAOs are already being used for various crowd-funding projects including charity / donations, buying NFTs and group investments.

Down The Rabbit Hole

The potential applications of the digital trust created by blockchain and crypto assets are almost endless. Through the examples above I’ve tried to offer a small glimpse of the kind of future that’s possible with their application. The fact that some of the smartest minds in Silicon Valley are working on this, as well as the fact that the asset class as a whole continues to grow despite the constant dire prognostications of naysayers, suggests to me that this is not a transitory speculative phenomenon and could very well represent the seeds for the next big technological revolution. That being said, like with any other emerging technology investment there are countless risks associated with investing in crypto. Below are three major topics I think investors should research in detail as a starting point before putting a dime into these assets:

1/ Not A Monolithic Asset Class

As I mentioned the blockchain has almost countless applications / use cases. As a result investors should ensure they understand the specific problem any given blockchain application, token or coin is trying to address before investing. Treating the sector like one big monolithic project is a mistake. For example Bitcoin was initially thought of as a future means of payments but is increasingly becoming a store-of-value play. This is because transactions on the Bitcoin blockchain remain incredibly slow, the value of Bitcoin remains highly volatile, and the Bitcoin community has pushed back against changes such as increasing the size of each Bitcoin block to allow more transactions to be processed per second. Given the lack of development and resistance to change, there is a consensus forming that Bitcoin is the equivalent of ‘digital gold’ or a way of protecting your wealth against bad central banking policy.

Compare this to the Etherium blockchain which wants to use the properties of digital trust to build a lot more than just a monetary database. The Etherium blockchain is being used to build decentralized applications for a number of the use cases I discussed earlier including a repository for identities, decentralized file storage, decentralized finance (DeFI), DAOs, NFTs among others. The Etherium blockchain currency ETH lets you pay a network of computers to run various applications that are built on top of it and in that sense is more of a ‘token’ rather than a ‘currency’ and referred to as such in the community. The fee paid in order to process transaction on the Etherium block chain is knows as a ‘gas fee’ and varies depending on how busy the network is at any given time. Recently these gas fees have become extremely expensive during times of peak usage as the amount of traffic on the Etherium network continues to grow fast.

In order for Etherium to achieve the stated objectives of its founders (i.e. build real-world tools and applications on the blockchain that can be widely used all over the world) it needs to constantly evolve. There are currently various updates under progress to help the Etherium blockchain process transactions faster and to improve scalability. Etherium therefore embodies the Silicon Valley ethos of ‘moving fast and breaking things’. But this also means that Etherium has more competition. While Bitcoin has nearly monopolized the ‘store of value’ application for blockchains, Etherium is facing competition from a slew of new entrants like Cardano and Solana that claim to have found better solutions to the problem of scalability. For example Solana uses the concept of Proof of History (PoH) as a technological improvement over Etherium to process a greater number of transactions per second (~700K transactions / sec which is ~30x the number of transactions Visa handles).

To conclude, successful investment in crypto requires an understanding of the different types of crypto assets and their respective use cases. Without this understanding you won’t know the risk / reward implications of what you are buying and are therefore likely be surprised by the ultimate outcome. Buying a meme coin like Dogecoin exposes you to very different set of risks vs. something like Etherium which has a significant ecosystem of developers working on solving real-world problems on the blockchain.

2/ Regulatory Overhang

It’s no surprise that the decentralized nature of crypto assets has attracted a lot of illicit activity. By circumventing the banking system, Bitcoin has allowed many types of criminals all over the world to transfer / launder money with ease. Just this summer Colonial Pipelines paid $5mm in cryptocurrency to a group of hackers from Russia who infiltrated the Company’s systems and caused a days-long shutdown of a major gas pipeline that led to a supply shortage on the U.S. East Coast. The FBI somehow managed to acquire the private key to the cyrpto wallet where the assets were held and retrieved $2.3mm (the price of Bitcoin had fallen), but the fact that the hackers asked for ransom in Bitcoin goes to show the increasing preference of nefarious actors to conduct their business in cryptocurrency.

While it’s estimated that only 1% of crypto transactions involve illegal activity, and the vast majority of money laundering continues to be in the form of fiat currency, the ability to own cryptocurrency without divulging your identity and the fact that regulators are behind the curve in terms of technology has alarmed policymakers all over the world:

“Cryptocurrencies have been used to launder the profits of online drug traffickers; they’ve been a tool to finance terrorism,” Treasury Secretary Janet Yellen.

“Very few people are using Bitcoin to pay their bills, but some people are using it to buy drugs [or] subvert elections,”  New York Times columnist Paul Krugman.

“[Bitcoin is] a highly speculative asset which has conducted some funny business and some interesting and totally reprehensible money-laundering activity.” ECB President Christine Lagarde

Additionally, the whole crypto economy extending beyond Bitcoin, Etherium and including all other tokens and meme coins continues to be unregulated and has turned a bit into the Wild West of the technology and financial world. The whole space is moving so fast that regulators are having a hard time keeping up with rising and continuously evolving forms of speculative activity. The creation of stablecoins and DeFi has led to an orgy of leveraged speculation in crypto assets manifesting in increased volatility and boom / bust cycles for many of the most traded coins as well as increasing the fragility of the entire system. The following passage from Financial Times captures the potential systemic risks posed by the asset class:

With the stablecoin market now $100bn+, regulators are starting to take note. On Nov 9th, SEC Commissioner Caroline Crenshaw published a statement on DeFi which should have rung the alarm bells for anyone in the crypto space taking regulatory risks too lightly. The statement makes it clear that while DeFi is ‘decentralized’, it’s still a subset of ‘finance’ and involves activities which have traditionally fallen under the SEC’s jurisdiction. I found the following few passages to be particularly noteworthy:

“But these offerings are not just products, and their users are not merely consumers.  DeFi, again, is fundamentally about investing.  This investing includes speculative risks taken in pursuit of passive profits from hoped-for token price appreciation, or investments seeking a return in exchange for placing capital at risk or locking it up for another’s benefit.”

“For example, a variety of DeFi participants, activities, and assets fall within the SEC’s jurisdiction as they involve securities and securities-related conduct. But no DeFi participants within the SEC’s jurisdiction have registered with us, though we continue to encourage participants in DeFi to engage with the staff.”

“That being said, for non-compliant projects within our jurisdiction, we do have an effective enforcement mechanism. For example, the SEC recently settled an enforcement action with a purported DeFi platform and its individual promoters.  The SEC alleged they failed to register their offering, which raised $30 million, and misled their investors while improperly spending investor money on themselves. To the extent other offerings, projects, or platforms are operating in violation of securities laws, I expect we will continue to bring enforcement actions.”

These statements suggest that regulatory crackdown on the whole space is only a matter of time. While the SEC has chosen to use an enforcement framework for now, I think a broader regulatory framework for crypto is probably on its way. While such a framework will add a lot more transparency and certainty, it will likely also lead to short term volatility, de-leveraging and potentially massive losses for some investors and speculators exposed to activities that will be made illegal, or severely constrained in scope going forward. It may also end up making DeFi a lot more like TradFi.

Perhaps the biggest reason to expect regulatory crackdown on the space is that governments will not tolerate a potential loss of confidence in fiat money and the banking system as a result of cryptocurrency adoption. Modern monetary policy relies critically on the central bank’s ability to increase money supply to encourage credit creation, and for all economic actors to continue treating this money as the primary means of economic exchange. If cryptocurrencies continue to rise in value, people could start to view this increase as a sign of uncontrolled inflation or the debasement of fiat currency. Such expectations can be self-fulfilling as people could start hoarding crypto assets and anchoring wage expectations to their price, starting a wage-price spiral. Additionally if people move from the current banking system to DeFi platforms, then the channels through which central banks exert their power (i.e. injecting liquidity / credit creation, regulatory frameworks etc.) will be neutered.

Based on all the above, it’s not surprising that China and India have effectively banned all cryptocurrency transactions, and leaders in the developed world continue to speak in a cautious and increasingly threatening tone about the whole space. More national bans and restrictions are almost a certainty in my opinion.

3/ Buying and Storing Crypto

Most crypto is bought and sold on major exchanges like Coinbase, Binance, Gemini etc. When choosing an exchange it’s important to consider security features, fees and capabilities. Some of the smaller exchanges may offer lower fees but they leave you exposed to security risks (hackers have broken into exchanges and stolen assets). In general it’s best to stick to the largest exchanges that have backing from big venture capital and other institutional investors. It also makes sense to transfer your assets to a private wallet off the exchange if you’re planning on buying and holding significant amounts of cryptocurrency for the long term.

While most big exchanges will store your assets in a secure wallet, security is not their primary business. Make sure to choose an exchange that will allow you to move assets off the exchange and into a private wallet. A ‘hot’ wallet runs on internet-connected devices like computers, phones, or tablets which makes it quite convenient to access your assets and transact. But because it’s connected to the internet, a hot wallet is also exposed to online security breaches and threats. The safest form of crypto storage is a ‘cold’ wallet or hardware wallet which is not connected to the internet. This could be in the form of a USB or hard drive, but requires more technical knowledge to set up. A good way to set up your wallets is to have an exchange account to buy and sell, a hot wallet to hold small to medium amounts of crypto you wish to trade or sell, and a cold / hardware wallet to store larger holdings for long-term durations.

Signing up for an exchange usually requires setting up an account and verifying your identity by submitting government issued documentation (though some exchanges allow anonymous accounts). However this doesn’t mean that your identity will be revealed on the blockchain. Blockchains record all the transactions you and everyone else is making and share it with everyone, but these transactions are linked to every user’s public key, not their personal information. This makes the transactions anonymous, but not confidential. A public address is where the funds and assets are deposited and received but only a private key allows you to retrieve those assets or make transactions with those assets. Think of a public address on the blockchain like a mailbox and the private key as the mailbox key. Anyone can put mail into the mailbox, but only you can access the contents of the mailbox with the private key. This is why keeping your private key somewhere safe is essential.

Conclusion

While there is a lot more to be said on the topic, I hope this post has been a good intro on the potential applications of crypto and some of the key research topics and risks associated with the space for investors to dig into further. I’m still early in the process of doing the same and hope to write more pieces that delve deeper into specific topics. For now I have decided to allocate a small % of my net worth (~1%) to a diverse basket of crypto assets to keep me motivated to learn more. It could be that I’m too early, or that the majority of the assets in the space eventually implode due to regulatory or other factors, but given the enormous potential and asymmetric upside I think it’s a worthwhile topic for all investors to keep an eye on.

Why Neither OPEC+ Nor US Shale Can Do Much About The Energy Crisis

In May 2020 I wrote a piece titled “Portfolio Update: How I’m Investing Now” where I predicted that the oil market would rebound quicker than people were expecting. I laid out three phases of the recovery process, with the last / third phase being characterized by oil inventories falling below pre-COVID levels and continuing to draw because of the multi-year underinvestment in supplies and structural damage to oil production from oil well shut-ins. I wrote:

As we have learned from Venezuela, Iran etc. once you damage the capital stock for oil producers, it’s extremely expensive to repair and restart. This is unlike a normal manufacturing process which can usually be shut down and restarted with minimal friction. Once an oil company shuts in a well, it may never restart the well as it may be uneconomic to do so until oil prices are much higher. Decline rates accelerate due to the lack of maintenance capex.  This is especially true for older, depleted wells that are less productive.

With oil prices hovering at around $25 / bbl and having just recovered from a trip to -$40 / bbl, what I wrote at the time was hard for most to believe and easy to dismiss. The ‘oil is dead’ narrative remained mainstream. Since then oil has nearly quadrupled to $80+ / bbl and inventories have not only normalized to 2019 levels but are on track to hit the 2018 lows.

Despite this drastic change in fortunes, most generalist investors remain skeptical of oil price recovery. The consensus narrative seems to be that OPEC+ has enough spare capacity to cure the deficit and that US Shale will eventually start ramping up production causing the market to slip back into surplus.

Since the oil and gas sector has been out of favor in the investment community for more than half a decade, these narratives are not surprising to hear. Most investors haven’t really focused on the structural changes happening in the industry and are still extrapolating from historical trends. There simply hasn’t been much incentive to conduct any deep study into a sector that represents <3% of the S&P500, and with recent ESG mandates the oil sector remains the farthest thing from what most institutional investors would consider to be a core area of interest. This is why I think the handful of energy specialists who have been tracking the underlying fundamentals over the last few years have a strong edge and will likely outperform the market strongly over the next few years . Under the gut wrenching month to month and year to year volatility in the oil markets are strong structural undercurrents that will completely re-define how the world thinks about oil and the energy sector more broadly.

To address these structural undercurrents I wrote a series of blog posts in 2019 titled “What Is The End Game For The Oil Thesis?”. In Part I I talked about how the world had been under-investing in conventional oil supply and how this would lead to increasing decline rates which would become impossible to reverse in the near term given the long lead times needed to sanction and build such projects. In Part II I wrote about why we can’t rely on US Shale to fill the gap from lack of conventional project capex. And finally in Part III I talked about why OPEC+ spare capacity is not as high as it appears. I also talked about the limitations to OPEC+ spare capacity in my most recent oil market update.

Since most investors haven’t been studying these changes in the industry, they are still operating under old / stale assumptions regarding supply growth and a false narrative of abundance. This extends to the political sphere with recent comments from the Biden administration displaying a shocking lack of understanding of the forces at play.

The result of this energy ignorance will ultimately be a steadily worsening energy crisis as politicians and investors continue to ignore the root cause of the problem and continue searching for short-term stopgap measures (e.g. SPR release, or oil export ban) or offer up completely unrealistic ‘green’ alternatives (e.g. switching completely to electric cars in the next couple of years).

Short term solutions like an SPR release will only briefly pause the rally in oil prices and will most likely result in governments needing to re-fill their SPRs at higher oil prices down the road. These reserves are intended as a backup / safety measure to ensure supplies in the event of a natural catastrophe or military conflict and are not a ‘real’ source of supply. An oil export ban ignores the reality that refineries require different grades of crude to operate. Domestic refineries in the US as an example would need to continue to import heavy / medium grade crudes from Canada and the Middle East to operate. An export ban would simply create an oversupply of lighter grade crudes in the domestic market and cause a widening of the WTI-Brent spread which would hurt domestic producers with no noticeable impact on gasoline prices to the end consumer.

Even more bizarrely some world leaders are of the view that high oil prices are not a problem because we will all start driving electric vehicles in a few years and oil demand will collapse. The current global vehicle fleet is around 1.3bn vehicles, of which around 11mm are electric. Yes, that’s Billions with a B and Millions with an M. So with electric vehicles at just under 1% of the vehicle fleet, how exactly are politicians envisioning a drop in oil demand from EVs?

Assuming the global vehicle fleet grows by 2% a year, the number of cars on the road will increase by 25 – 30mm vehicles a year, so EV sales of 25mm-30mm are required (i.e. 3x the current EV fleet) just to keep oil demand FLAT. And this is assuming no growth in oil demand from air travel or petrochemicals which make up almost 60% of total oil consumption(!). Manufacturing EVs at this scale would require enormous volumes of raw materials like aluminum and lithium which are highly energy-intensive to produce. ~10% of oil demand comes from the mining sector. What do you think will happen to oil demand if we decided we wanted to triple the production of lithium and aluminum in short order? What kind of investments and lead time will be needed to produce these raw materials on such large scale?

Even if we leave all these issues aside and assume the world is able to miraculously achieve these absurdly unrealistic EV sales figures, the politicians will still need to address one more critical question: where will the power come from to charge the EVs? A quick look at the global power crisis and electricity shortages all over the world will immediately expose the vacuous nature of these claims.

Not only would the world need to invest massively in clean electricity sources, it would also have to develop the grid infrastructure (backup generation for renewables, charging stations etc.) to make mass EV adoption realistic. This is a multi-decade undertaking, not something that will be resolved over the next few years.

The root cause of the energy crisis which no one (except for a handful of specialist energy investors) seems to want to talk about is encapsulated by this chart from Goldman Sachs showing investment in the biggest oil projects they are tracking globally:

Here is another one from J.P. Morgan for a more comprehensive global oil capex outlook:

$600bn of ‘missing’ capex is not a problem that will be resolved by SPR releases or export bans. And wishful thinking about electric vehicle adoption and peak oil demand will only make this worse as it will continue preventing the necessary investments needed to ensure sufficient oil supplies for the future. In a way it’s already too late: even if oil companies started investing today, it’ll take 4-5+ years to bring new projects online which means that energy security will be a problem for the foreseeable future. With supply inelastic in the near term demand destruction will be the only way out, and it will happen not because of electric vehicle adoption as many believe, but sky high oil prices which will bring the world economy to its knees. The politicians and investors looking to OPEC+ or US Shale to increase supplies to lower oil prices should look at their own actions first. After sowing the seed for this energy crisis, they must now reap the consequences. Unfortunately it’s the working classes that will bear the brunt of their misguided policies.

Some Thoughts To Close The Year (Part 2)

The US Dollar – Start Of A New Cycle?

The US runs persistent current account deficits (which is bearish for the Dollar), while creditor economies like Germany and Japan run current account surpluses. Therefore, the only way for the US dollar to demonstrate strength against these currencies is through relatively tighter monetary policy.

The most recent cycle of dollar strength started in mid-2014 when the US ended its quantitative easing program. In early 2018 the Fed started quantitative tightening which eventually caused a significant correction in the US stock market. These policies made US monetary policy relatively tight vs. the rest of the developed world and led to the relative strength of the dollar during this period.

Post-COVID the situation has changed. US monetary and fiscal policy has become looser and the US Dollar has plenty of room to fall. The demand for USD has been fairly stable, but the supply has gone up due to the recent loosening of policy. Now you could point to nominal interest rates and say that despite the looser monetary policy, USTs still offer a better yield vs. say German bunds. But it’s important to keep in mind that on a real / inflation adjusted basis USTs are now also yielding <0% and with the Fed likely to increase its asset purchases, real yields are unlikely to rise significantly from here.

Since Fed policy is going to remain loose for the foreseeable future, we could be entering into a structural bear market for the dollar in the coming years. The US Net International Investment Position (NIIP) is now over -60% of GDP, which is nearly triple the level at the beginning of the last dollar bear market (2005). NIIP is defined as the difference between the value of foreign assets owned by the U.S. and U.S. assets owned by foreigners. What this means is that the world owns a lot more of the US, than the US owns of the world. And if lots of people try to leave the market the dollar will go down significantly.

Source: U.S. Bureau of Economic Analysis

If you look at the US Dollar from a historical lens it tends to move in multi-year bull and bear cycles that highlight these structural shifts in monetary policy and trade regimes over the years. Since 1971 (when Nixon removed the dollar from the gold standard) the dollar index has had 3 secular bull and bear markets:

Source: TheAtlasInvestor.com

Looking at the USD vs. Euro shows a similar picture.

Source: Currency Research Associates LLC

These secular shifts have important implications for asset allocation. If we are indeed in the beginnings of a bear market in the dollar, it will likely last at least another 7-10 years and investors who are over-exposed to USD denominated assets will have to reallocate capital. As investors do the math around FX losses, they will start to re-allocate their portfolios to asset classes such as emerging market stocks and commodities which benefit from a weaker Dollar.

Concluding Thoughts

Markets are cyclical. Today, US stocks trade at record high valuations while commodities are historically cheap. Due to the unprecedented monetary environment we are in, I think the current equity market bubble could continue longer than most expect. I certainly wouldn’t recommend something risky like shorting US equities. However I also believe that risk / reward for owning USD denominated bonds and equities is steadily deteriorating.

Source: Crescat Capital

Investors should consider reallocating capital towards commodities and emerging market stocks. Both sectors remain deeply undervalued and underinvested.

I have written extensively on oil and gas and I continue to believe that the energy sector will be a primary beneficiary of the next macro / investment cycle. Investors continue to be obsessed by peak demand theories but I believe that peak supply is going to hit faster and sooner, catching the majority of investors off guard. In fact if it wasn’t for US shale (another Fed induced bubble!) the market would already be in a structural deficit.

Source: GS Research

With sentiment extremely negative for the sector, capital access has dried up and oil & gas companies have been forced to cancel all major longer-term exploration and production plans. 6 years of under-investment are about to the hit the world’s oil supplies over the next few years creating one of the best investment opportunities in the sector since the last decade.

Source: GS Research

Finally, I continue to have an allocation to gold and silver as I believe precious metals are starting a new secular bull market in response to monetary debasement. The big financial story of 2020 has been the record quantities of money printed by central banks to finance budget deficits and shore up liquidity.

Source: Crescat Capital

As this money starts trickling into the real economy (esp. with additional fiscal stimulus), inflation expectations are rising. With nominal rates stuck at the lower bound, bonds and cash are becoming increasingly unattractive as stores of value. Gold is one of the oldest currencies in the world and should attract more investors as an alternative safe haven. As I wrote in my detailed piece on the gold thesis, the metal remains extremely under-owned in most Western investment portfolios.

Over the long term Gold shows strong correlation to real rates (inverse) and M2 (money supply), both of which are firmly set in their trajectories given where we are in the long-term debt cycle.

Source: Gold-Eagle.com

A closer look at the gold chart reveals that we could be on the cusp of a major secular bull market, similar to the breakout in 2005. From 2005 to 2012 gold appreciated ~4.5x. A similar move would take gold prices well above $8000 / oz.

Source: TradingView

In the meantime, gold miners are the cheapest they have ever been in 20 years on a forward P/E basis. Looks like an asymmetric risk / reward profile.

Source: Bloomberg.

Some Thoughts To Close The Year (Part 1)

I wrote two pieces about the Coronavirus earlier this year. The first piece written on March 2nd talked about how the market had underestimated the impact of the virus and the mishandling of the situation by politicians. However, I ended on a sanguine note suggesting that the market sell off presented a buying opportunity and that the crisis would likely abate in 3-6 months as countries would manage to ‘flatten the curve’.

On March 21 I wrote in a more cautionary tone, warning that the virus could cause longer-lasting social and economic impacts. By this time I had done more reading on the topic and was no longer as convinced that things would return to normal within a few months. I warned about the risk of secondary / tertiary outbreaks. I also wrote about the impact of the lockdowns on small businesses in particular and highlighted the possibility of political instability and social unrest.

6 days after I published this blog post, the US government addressed a number of these concerns by passing into law an unprecedented $2.2 Trillion stimulus packaged titled the “CARES Act”. The stimulus bill offered direct payments to individuals and families to help cover their daily expenses. Small businesses and certain targeted industries received aid in the form of forgivable loans to help them keep employees on payroll. State and Local governments also received funding to help combat the virus.

While the stimulus has certainly been welcome news for the general population, it has benefited some more than others. The stock market, the bond market and the housing market are all at all-time-highs, meaning that if you’re an asset owner you have seen your net worth increase substantially during this period. On the other hand if you live pay-check to pay-check, you are likely suffering from low wages, job insecurity and under-employment. This has led several people to refer to the economic recovery as the “K-shaped” recovery; i.e. one that is exacerbating already high levels of inequality.

The longer-term implications of the stimulus bill for both asset prices and the economy is not well understood by the recipients of this money, nor the mainstream media. Economics tells us there is no such thing as a free lunch, and America’s (as well as most of the developed world’s) current fiscal trajectory and associated debt binge is going to have important implications for the nation’s future economic growth and prosperity. I talked about this in detail in my big picture piece titled “A Possible Path Forward” on April 30th. I discussed several examples of historical debt cycles to try form a hypothesis on how the current cycle is likely to play out.

While we might see an uptick in economic growth next year due to pent up demand, I continue to believe that the longer-term picture for economic growth remains weak. Due to a combination of high debt levels, flattening productivity and deteriorating demographics, a secular stagnation is most likely on the cards for most of the developed world. And governments, as they have always done in history, are likely to respond to this with even more (and increasingly creative forms of) stimulus. This will ultimately result in debt monetization, monetary debasement and potentially hyperinflation.

In order to protect one’s wealth against this inevitable currency debasement, it’s important to own (directly or have indirect exposure to the value of) hard assets such as precious metals, land and commodities etc. I wrote a detailed piece on how gold can serve as an effective hedge against this scenario and why it should be a part of every investor’s arsenal. Bitcoin is emerging as another alternative that is worth exploring.

Equities – The New Inflation

Before the end of the debt cycle, we are likely to see the equity bubble peak. Over the last 10-years, the S&P500 has returned an annualized return of ~11.5% while the NASDAQ has returned ~20%. These are well above the long-term historical average equity returns (history teaches us that asset-class returns are mean-reverting). Valuations are also close to their all-time peak.

One could argue that current valuations are justified given the record low interest rates. However, with interest rates close to their lower bound, one can also argue that there is not much more that be squeezed out of equity valuations based on lower discount rates alone.

The other fundamental driver of equity valuations is earnings or cash flow growth. Organic growth (primarily tech sector), margin expansion, M&A and share buybacks are the primary earnings growth drivers.

Organic growth in the tech sector could start to slow as the big tech companies take increasing share of their total addressable markets. Also, with competition steadily increasing, so is the marginal cost of acquiring new customers. COVID-19 has also pulled forward a significant amount of growth for certain tech sub-sectors like e-commerce, online food delivery and enterprise software.

Margin expansion is reaching its limits as years of high M&A volumes have led to major consolidation in most sectors, and further consolidation opportunities are limited. In fact, recent political developments point to increased regulation, corporate taxes and de-globalization which will exert downward pressure on profitability.

With these fundamental headwinds, how can we make sense of the seemingly never-ending stock market rally? One explanation is money printing. The Fed is currently buying $120bn worth of mortgage backed securities and treasuries every month. A lot of that liquidity flows into the stock market.

The other explanation is irrational exuberance amongst retail investors who are buying stocks mostly on a speculative basis. There are multiple data points from this year that point to this. Retail trading and call option buying volumes for example have been at record levels. Even some large institutions like SoftBank have been adding fuel to the speculative frenzy, buying billions of dollars worth of naked call options on technology stocks.

Source: Autonomous.com

Source: Sentiment trader

Receptivity towards speculative investments such as SPACs and money-losing IPOs is another sign. The ratio of U.S. IPOs with negative vs. positive net income in the past year dwarfs even the dot-com bubble peak.

Meanwhile hedging remains out of fashion as evidenced by record low put-call ratios. Whatever investors are worried about, a falling equity market is definitely not it. Thanks to fed intervention and recent price action, most market participants have been psychologically conditioned to expect higher stock prices. As a result every dip gets bought, and equity valuations veer farther and farther from underlying fundamentals with every rally.

It seems to me that the equity market has come to reflect the inflation that many have feared in response to the unprecedented expansion of central bank balance sheets that started post the GFC. Instead of getting a ‘CPI inflation’ shock where we would have experienced rising prices for daily goods and services, we are instead having to chase every dollar of corporate earnings higher in terms of valuation multiple in the stock market. Equity valuations have become a reflection of monetary debasement rather than the value of ownership stakes in the underlying businesses.

None of this means that we will have a bear market in stocks anytime soon. In fact, given the continuous money printing, low interest rates and trillions of dollars of capital still on the sidelines that is waiting to be put to work, the equity market bubble could become even more extreme. However this does mean that if you have a large naked or leveraged exposure to equities you are playing with fire.

Asset bubbles don’t always need a catalyst to blow up. Sometimes they collapse under their own weight. A correction when it happens, could come without warning and be deeper and faster than most expect due to the lack of fundamental / valuation support and one-sided positioning. During the 350% run in the NASDAQ during 1998-99, there were plenty of 10 – 20% corrections. If you’re long options for example it’s important to to buy enough time to ride through these corrections, or alternatively own some hedges.

To experience something more prolonged than a temporary correction (i.e. a bear market), we would need a Fed tightening cycle. All the recent bear markets in equities were the result of Fed tightening which led to a flattening or inverted yield curve and drained liquidity from the market. The Fed did this in response to rising inflation expectations. However, this time around the Fed has made it clear that it is willing to let inflation run above target. Translation: the secular bull market in equities could go on as long as inflation doesn’t go so far above target that it forces the Fed’s hand. After that point, we are likely to get a mean reversion in returns. Equities could then underperform for an extended period of time, similar to the 1970s.

Source: The MacroTourist

Bonds – “Return-Free” Risk

If you buy a 10-year US treasury bond today and hold it to maturity, current inflation expectations suggest that you will lose close to 1% a year. Yet investors continue to buy record amounts of US Treasuries to fund America’s never-ending deficits.

This is not a problem limited to the US. The vortex of negative yielding debt grows by the day, currently close to $18 trillion outstanding. As I stated earlier pretty much all the developed world is in the same predicament. Due to record-high debt levels, nominal interest rates are stuck at the lower bound and lenders (i.e. bond buyers) are essentially guaranteed a negative return in real-terms unless the world falls into a deep deflation or nominal rates continue lower into negative territory. Both those outcomes are unlikely as the central banks won’t allow it.

A deflationary spiral is a central banker’s worst nightmare and deflationary forces will push policymakers towards even more money printing, and potentially enacting something along the lines of Modern Monetary Theory (MMT) to spark inflation. As I stated earlier, the Fed has indicated repeatedly that they see no signs of inflationary risks and are even willing to let inflation run higher than their 2% target for a while as they think about inflation on a longer-term average basis.

With the developed world increasingly pushing the pedal on fiscal (on top of monetary) stimulus, the stage is set for a pick up in money velocity and inflation expectations. For the first time since central banks started structurally expanding their balance sheets post the GFC, it appears the money being printed could end up in the hands of the average person (as opposed to the owners of assets) and start circulating through the real economy causing inflation expectations to rise significantly. This would be further exacerbated through the release of pent-up demand in a post COVID world which is supply-chain constrained.

With nominal yields stuck at the lower bound, any increase in inflation expectations will quickly deepen the losses for investors buying bonds today. The US dollar has also been steadily weakening, creating a double whammy for foreign holders of US Treasuries. It’s important to remember that the bond market is many multiples the size of the equity markets and the exits from this trade are narrow.

If losses on bond positions start to pile up, the global financial system could break under the strain of investors trying to get out. As we learned from the GFC, any disruption to the flow of credit / bond markets unravels the global economic system quickly. The pension system could also unravel. Pension funding relies on certain assumptions regarding future equity and fixed income returns that could prove to be significantly higher than reality. This is a systemic risk that most investors seem to be ignoring at the moment.

Biden Presidency Is A Tailwind For Oil

I’ve discussed in detail in several posts how the lack of capital investment in the energy sector is going to lead to a strong bull market in oil in the coming years. I believe the thesis will only get stronger with Biden as president.

The Democrats have been leaning strongly towards anti-fossil fuel policies, and Biden has mentioned several times that he wants to ‘phase out’ oil and eliminate fracking (which accounts for the majority of the US Shale sector) during his campaign.

Based on what’s been said publicly, the Biden energy policy will be centered around the following three pillars, all of which will curtail future oil production growth in the US:

– Federal drilling ban

-Limiting natural gas flaring

– Slowing down approvals for energy infrastructure/ pipelines

Platts estimates that a Federal drilling ban alone could impact US oil production by 2mm b/d over the next 5 years. This 2mm b/d will be desperately needed post-COVID given the declines in Non-OPEC ex-US production. The US oil sector has already been suffering from capital starvation as investors have fled the sector, and the new regulations could mean that US oil production may never recover its peak level of 13mm b/d.

What are the implications of this for supply / demand and oil prices? We can look at some of the post-COVID projections to try and quantify the impact.  

Most of the big energy analytics firms were predicting an oil market deficit in 2020, pre-COVID. This was with US production estimated at 13.4mm b/d. It appears that US production is now likely to top out at around 11 mm/d.

If we look at oil demand growth over the last 10-years, it’s averaged +1.5mm b/d. But because of COVID, a number of folks are arguing for structurally lower demand growth going forward (more people permanently working from home and less travel overall etc.).

I disagree with this view and have a more bullish outlook on oil demand recovery. I believe there will be strong pent-up demand for travel post-COVID. Also, as GDP per capita grows in places like China and India, the expanding middle class population in these countries will start buying their first cars / motorcycles / airplane tickets which will increase oil demand significantly.

I also believe strongly that electric vehicles are not going to be able to replace conventional vehicles in any significant way to meet this increasing demand over the next 4-5 years (I will write more on this in a follow-up blog post).

However, for the purpose of this analysis let’s be conservative. Let’s assume the IEA, which has historically always underestimated demand growth, is correct this time in their assumption of 750k b/d oil demand growth in the post-COVID era.

2019 oil demand was around 100.2mm /d. 2020 is forecasted to be around 93.3mmb/d. If I forecast oil demand recovery back to 100mm b/d by 2022, and then 750k b/d of growth from there onwards I get 102.5 mm b/d of oil demand for 2025.

2021 – 2025 Oil Demand Growth: +9mm b/d

Plus: 2021 – 2025 Non-OPEC Ex-US Declines: +1.5mm /bd (assuming -0.3mm b/d decline per year)

Less: 2021 – 2025 US Supply Growth: -0.5mm b/d (assuming production caps out at 11 mm b/d)

2021 – 2025 Call on ROPEC:  +10mm b/d

Based on this math, even in a draconian oil demand recovery scenario, OPEC would have to increase production by 10mm b/d over the next 5-years to keep the market in balance! Is this a realistic ask of OPEC?

A few points to consider:

1/ Including Iran and Venezuela, OPEC spare capacity is ‘theoretically’ ~9mm b/d at the moment. Realistically speaking however, Iran and Venezuela’s ability to increase production will be limited over the next year or two (even if sanctions are removed) because of the severe lack of investment in their oil production infrastructure over the last few years

2/ It is also not realistic to assume that the rest of OPEC can produce at maximum capacity for an extended period of time as this would put enormous strain on the oil wells and potentially lower ultimate oil recovery. For reference, OPEC produced close to 32mm b/d during the 2018 ‘surge’, which would imply a 6mm b/d capacity (ex-Iran and Venezuela). Assuming the Biden administration removes sanctions on both countries (which is not straightforward by any means), we can maybe add +1-2mm b/d to that number. So we are still short of the 10mm b/d requirement by some margin.

3/ The OPEC economies have been devastated as a result of the recent oil price declines and will not be able to recover the damage to their fiscal situation unless oil prices are above $80+ for an extended period of time. This means that even if they theoretically had the ability to balance the market, their desire to do so would be limited and they are likely to keep production cuts in place for an extended period of time

If we assume a more realistic oil demand recovery scenario where demand recovers to 100mm b/d by 2022 and then grows at the historical rate of +1.5mm b/d thereafter, then in 2025 total oil demand will be ~104.8mm b/d. The math will then look like this:

2021 – 2025 Oil Demand Growth: +11.5mm b/d

Plus: 2021 – 2025 Non-OPEC Ex-US Declines: +1.5mm /bd (assuming -0.3mm b/d decline per year)

Less: 2021 – 2025 US Supply Growth: -1.5mm b/d (assuming production caps out at 12 mm b/d)

2021 – 2025 Call on ROPEC:  +11.5mm b/d

In this case I’ve assumed that US Shale is able to recover to 12mm b/d given that the larger demand swing might allow the Shale sector to attract incremental capital and return to some semblance of growth in the post-COVID world.

This is the more likely scenario in my opinion, and results in a supply deficit so large that demand destruction would be the only way to balance the market. If we look at oil price over long periods of time, demand destruction usually starts when oil consumption starts hitting 5% of GDP. This would equate to oil prices in the $120 – $150+ range.

The Case For Gold

In my April blog post titled ‘The Possible Path Forward’, I wrote a brief blurb on why an allocation to gold made a lot of sense in the current environment. In this post I want to elaborate more on the thesis by defining more precisely what I think gold represents, and the key macro drivers impacting its price.

Despite the strong rally in gold recently (+15% since my original post), I believe prices are going much higher than most people expect.

The Case for Gold

Often looked upon as a relic of the barbaric ages, gold is usually shunned by institutional investors who consider it to be a speculative instrument better suited for retail investors or gold ‘bugs’. The anti-gold argument goes something like this: It’s a non-productive asset whose value is determined purely by investor sentiment / perception. One can only profit from gold as long as someone is willing to purchase it at a higher price at some point in the future. And while this is true for all financial assets, the future price of ‘productive’ financial assets is backed by the present value of the cash flows they generate. In the case of gold, it just ‘sits there’.

Unfortunately, this line of thinking misses the true essence of gold. I believe that gold can be incredibly powerful in a portfolio during certain macroeconomic regimes / environments. And I believe that due to COVID-19 and the ensuing fiscal and monetary stimulus, we have entered such an environment. The fact that gold remains deeply misunderstood and under-owned therefore represents an opportunity.

At its core, gold is a currency. It’s therefore incorrect to compare gold to stocks or other financial assets that generate cash flow. The best way to think about gold is as a means of storing value (which is true of all currencies), especially during times of uncertainty.

Historically, gold prices have been extremely volatile and most investors have preferred holding cash, or treasury bonds for this purpose. But during a few times in history, a confluence of economic, political and monetary circumstances has made the value of gold shine brighter than the traditional alternatives.

One such circumstance is when trust in central banks and governments starts eroding. Both cash and treasury bonds are backed by centralized institutions with opaque power structures that are often incentivized to find short-term solutions to economic and political problems, at the expense of long-term outcomes. History warns us that putting one’s complete faith and trust in these institutions and their short-termism can occasionally lead to disastrous results (e.g. sovereign debt defaults, hyperinflation etc.). This creates demand for an alternative safe asset. Preferably one that lies outside of the financial system.

My sixth sense tells me that we are in a situation where trust in centralized authorities is fast eroding, both in the developing and developed worlds. Government response to COVID-19 and the resulting economic damage has started to make people feel vulnerable in ways they maybe haven’t in more than a century. Populism, civil disorder and geopolitical tensions are all on the rise.

Despite the extraordinary measures governments have taken to backstop the economy and inject liquidity into the financial markets, a deep sense of unease remains. Perhaps at a fundamental level most people realize that there is no such thing as a free lunch in life. If free lunches don’t apply to our daily lives, why should they apply to governments and other institutions? If every problem could be solved by taking on more debt and printing more money, then we should have effectively de-risked the entire global economy from any kind of downward shock.

It’s not the first time people have asked these questions and felt uneasy about programs such as quantitative easing. Starting 2009, gold prices appreciated significantly (reaching as high as $1900 / oz) as investors expected that the cost of this seemingly free lunch (in the form of Fed’s money printing) would be higher inflation down the road. Inflation would make holding cash and bonds extremely unattractive, and this led to the rise of gold.

However, the inflation that people had feared never materialized. Asset prices continued to appreciate, but CPI inflation remained absent. The US Dollar remained strong and bonds continued to perform well as a hedge against macro uncertainty. As economic growth continued, faith in the authorities was somewhat restored and there was an expectation that the Fed would eventually normalize both it’s balance sheet and interest rates. Gold slowly lost it’s shine and entered into a brutal ~6-year bear market, bottom’ing at around $1050 in late 2016 / early 2016 and then trading sideways for another 3 years.

Towards the end of the decade, everyone had come to accept that quantitative easing was not inflationary, and perhaps this meant that gold could once again be relegated to the archives of financial history. But then something interesting happened. In late 2018 the Fed tried to normalize monetary policy, and the markets puked. If quantitative easing and low interest rates had really been so successful in generating sustainable economic growth, then surely the markets should be able to perform well without the aid of central bank stimulus?

It turned out the answer was a resounding ‘no’. As the Fed raised rates, the yield curve started inverting (predicting that monetary policy normalization would lead to a recession) and stocks dropped sharply.

Then in 2019, global growth began to slow. It was becoming clear that monetary policy normalization was a myth, and that things were likely headed in the complete opposite direction: central banks were going to have to issue more stimulus to reflate the global economy. In the summer of 2019, realizing that central bankers had been painted into a corner, gold started breaking out of it’s downtrend.

With interest rates already starting from a very low level, people wondered if the authorities were running out of ammunition for the next big economic contraction. They didn’t have to wait long to see how this scenario would play out.

Thanks to COVID-19 the future paths for fiscal and monetary policy, which were already shifting in favour of gold, are now in the ‘red zone’: we have reached a ‘Keynesian tipping point’ of no return.

Some would argue that this view is short-sighted and that a strong economic recovery post-COVID could allow governments to de-leverage. But as I have stated in previous blog posts, I believe that a combination of deteriorating demographics and productivity headwinds will keep economic growth low and fiscal deficits high even in a steady state economic environment. This is true for the US, Europe and most of the developed world (I called it the ‘Japanification’ of developed economies).

If you are wondering why the US 10-year treasury is yielding 0.6%, and why trillions of dollars worth of sovereign debt is trading at negative yields, this is the answer. Central bankers have been snookered: they can’t raise rates or stop buying government bonds without blowing up the world economy.

So what does this all mean, and how is it relevant for gold? I think one of the key takeaways from the current scenario is that that the risk-reward of holding cash or bonds as a store of value has never been worse. The value of cash is eroding quickly as central banks increase money supply at prodigious rates to fund ever persistent deficits. And bonds offer an awful asymmetric payoff profile; with interest rates already at the lower bound and stuck there for the foreseeable future, the upside in bonds is limited while there is potentially unlimited downside under an inflationary scenario.

I also think that the risk of CPI inflation (which never materialized post-GFC) is greater this time around. The reason for this is two- fold: 1) the state of the banking sector and 2) state of globalization. In 2009, banks were poorly capitalized and looking to preserve liquidity. As a result, Fed money printing was not accompanied by a proportionate increase in lending and the velocity of money and inflation remained in check. Additionally, globalization (in particular China) was a strong deflationary force as the cost of production for goods / services declined rapidly due to outsourcing.

In the current crisis, banks are adequately capitalized and more likely to extend credit. Also, globalization has gone into reverse thanks to the US-China trade-war and the supply chain susceptibilities exposed by COVID-19. Both of these factors are strongly inflationary.

We have now arrived at the bull-case for gold:

1. Debt levels have exploded globally
2. Due to a combination of demographics, low growth and bloated welfare state budgets, debt levels will continue increasing in the developed world for as far as the eye can see
3. This means that the window to increase interest rates and normalize central bank balance sheets is now gone
4. Money supply will likely continue increasing to absorb sovereign debt issuance, as not doing so will drain liquidity from the financial system and put the fragile economic recovery at risk
5. This means that cash and government issued bonds are going to be increasingly unattractive as a store of value
6. Inflationary risks might also be on the rise, making the downside case for cash and bonds even scarier
7. In light of all of this, it’s prudent to look beyond the financial system for a store of value whose supply can’t be influenced by the authorities
8. Gold has acted as a store of value and the foundation of a free market economy for centuries, yet it remains completely ignored in most investment portfolios

As you are reading these points, you will notice that there are a lot of similarities between the bull case for gold today, and the one made post the GFC. In fact, we are still in the same thesis. The only difference is that somewhere in the middle, the world was fooled into thinking that we could somehow grow ourselves out of the debt problem, and that this would eventually allow central bankers to normalize interest rates and money supply.

Arriving at a Price Target

This is the hard part, as it’s not an exact science. As I stated at the beginning of this piece, gold is not a productive asset and therefore you cannot apply traditional valuation techniques to arrive at its fair value. However, looking at the value of gold relative to other assets over different cycles historically can give us some clues.

One ratio I find particularly interesting is the ratio of M1 to the value of gold above the ground. M1 is a measure of money supply including physical currency, demand deposits and other ‘near money’ instruments. The thinking behind this ratio is that if central bankers keep increasing M1 through money printing, then gold prices relative to M1 should appreciate as gold will be relatively more attractive to cash as a hedge against monetary debasement.

Paul Tudor Jones published this chart showing that this ratio has reached as high as ~96 during extremes of gold bull markets and ~25 – 37 in other cycles. This would argue for a fair value of gold between $2000 and $6000 / oz based on where M1 is today. But the bull thesis doesn’t stop there, because we all know that M1 is only going one way in the future. This means that there is an opportunity to compound value holding gold for many years to come as central banks flood the economy with money.

The other way to think about the value of gold is through demand. Currently, most Western investors have zero or close to zero exposure to gold. But as banks / sell-side institutions change their tune and start recommending their clients allocate more to the metal, inflows into ETFs like GLD (which are backed by physical gold) will drive gold prices up. The table below quantifies what this demand would look like if institutions decided to hold 5% or even 2% of their AUM in gold:

Finally, we can think about the price of gold relative to financial assets. While I stated earlier that the two are not directly comparable, this ratio represents the relative preference of investors for risky assets vs. safe havens. If investors start doubting the economic recovery, or if geopolitical tensions rise, or if we get hyper inflation or deflation, stocks will not be a very attractive asset class to hold. This would lead to a rotation out of stocks into safer assets; cash, bonds, and (as I believe) increasingly gold.

Gorozen published the following chart in 2018 showing the historical ratio of gold price to the Dow Jones Industrial Average, which reflects relative investor preference between gold and stocks:

During historical gold bull markets, the ratio bottom’ed at somewhere between 1-6x, which would imply a gold price of somewhere between $4500 and $27K / oz.

How to Play This?

There are several avenues to consider depending on risk tolerance. For the highest returns one can consider buying call options on gold futures or on ETFs like GLD. Obviously with options one has to keep timing considerations in mind (especially given how volatile precious metals prices can be) and the fact that leverage cuts both ways.

The next alternative on the risk curve is investing in junior miners (GDXJ) and larger cap miners (GDX). The mining sector remains undervalued relative to it’s free cash flow generation and balance sheet quality at current gold prices. Due to operating leverage, these equities have levered upside to gold prices.

Finally, for the most risk-averse investors just buying and holding bullion exposure through GLD, or in physical form is probably the best way to go.

A Possible Path Forward

The past few weeks have been the equivalent of drinking from a firehose from an investment process perspective. There is a barrage of coronavirus-related news updates, macro forecasts, company updates etc. that I read every day and it often feels overwhelming. I’ve realized that it’s important to cut out the noise and focus on my circle of competence. In this case that means the energy sector. I’ve also started taking a closer look at gold. I will write more detailed articles on these topics later.

The purpose of this piece it to zoom out, take a forty-thousand-foot view of things. What does the world look like? Where are we headed?

I will lay out a few potential paths forward, but I’m generally in the same camp as Charlie Munger (from a recent WSJ interview):

“Nobody in America’s ever seen anything else like this,” said Mr. Munger. “This thing is different. Everybody talks as if they know what’s going to happen, and nobody knows what’s going to happen.”

I think the global economy will eventually recover from this crisis, but no one knows how long this could take. If someone put a gun to my head and asked me to provide a range, I would say we are probably 1-3 months from the major developed economies starting to re-open and 6 – 12 months from a full re-opening. After a full re-opening, I think it’s anyone’s guess how long it takes before we recuperate the loss in GDP and employment. I think a V-shaped recovery is unlikely for reasons I’ll go into more detail below.

It’s also important to think about structural changes to the economy, consumer and corporate behaviour that will define the next economic and market cycle. What do these changes mean for different asset classes and for specific sectors / companies? These are all questions that need to be answered before being able to invest with conviction in this environment.

For example, what happens to consumer confidence and the savings rate when we come out of this crisis? A lot of folks in the V-shaped recovery camp speak of ‘pent-up’ demand. But what I see is permanent cash flow and wealth destruction due to the closures. In the US, we have lost 20+ years of employment gains. Those jobs are not going to come back all of a sudden. Some of the unemployment could be structural as industries such as commercial real estate and tourism are probably not going to return to pre-COVID activity levels for a while. As a result unemployment could plateau at a higher rate. A lot of small / medium sized businesses will also be shut down permanently.

As a result I see a significant hit to consumer confidence, a further loss of trust in ‘the system’ (how come nobody in the government saw this coming?). This means a higher savings rate, possibly for several years. Since consumption is ~70% of the economy, it’s hard to get a V-shaped recovery in this scenario.

On the corporate side, the days of aggressive share buybacks and debt-funded acquisitions (both of which have been a major contributor to the earning growth and multiple expansion since the 2008 / 09 crisis) are over. Companies are going to be more conservative with their capital structures as they will be at risk of losing their credit ratings. The tech sector, which has been a huge contributor to margin expansion for the S&P500, has already reached close to peak profitability. This means earnings growth could remain muted for a while going forward.

Some sectors like commercial real estate may see a structural decline. Since companies have already invested in the infrastructure and logistics to help their employees work from home, does it still make sense to rent out expensive real estate in core metropolitan areas?

Governments will come out of this crisis with large fiscal deficits, high debt burdens and an electorate that is incredibly frustrated by poor planning and lack of foresight that allowed the virus to ravage through their societies and economies in this way. I increasingly hear the comment: “I can’t believe this is happening is America!” on my Twitter and news feeds.

This means that govt’s will likely need to raise taxes on corporations and wealthy individuals and in general enact more extreme wealth redistribution policies to appease the rising tide of populism. There will be a temptation to deflect blame / point fingers at others (notice Trump’s recent comments on China).

It is also likely that govt. will require more companies to move manufacturing back to their home countries. The crisis has laid bare the risks of complex global supply chain dependencies and there will be a strong push to regain control over the manufacture of essential goods, services, medications etc. Globalization has been hit with a severe blow and there will likely be a massive rework of supply chains going forward which will lead to dis-synergies. Decades of economic progress achieved through economies of scale and comparative advantage may have to be undone.

Finally, we are in uncharted waters with respect to monetary policy. Central banks are increasing the size of their balance sheets at an unprecedented rate. Interest rates are close to zero for most developed economies and are likely to stay there (or even go negative) given the large amounts of debts that will need to be serviced coming out of this crisis. The boundaries between free markets and central planning are being blurred as central banks have started buying risky financial assets such as investment grade and high yield bond ETFs.

What kind of moral hazard and market imbalance will this create down the road? Are the Fed and US Govt. saying companies should not face the consequences of their capital structure and capital allocation decisions? I agree that employees need to be protected, but we need to figure out a way to keep people employed while ensuring that financial asset owners are not getting the message: “capitalism for gains, socialism for losses”.

Those in the lower tranches of the capital structure get compensated with higher returns in exchange for higher risk. That’s the basis of a properly functioning capital markets.

The post GFC monetary regime has already been accused of exacerbating inequality by catalyzing a secular bull market in financial assets. Will the latest heavy dose of money printing make inequality even worse? As I say this, the stock market has rallied ~30% from it’s recent March lows while unemployment has hit levels we haven’t seen in generations.

The Lesson From Japan (And US History)

I’ve often looked at the macro trends in the developed world and thought we are all heading towards a Japanification of the economy. Productivity growth has flattened out, demographics are becoming a drag (people living for longer, less people having children), debt levels are rising and new technologies have been incremental vs. game changing for economic growth (read my book review of “The Rise And Fall Of American Growth”).

Japan has struggled with low growth and the risk of deflation for years, and the Coronavirus may have pushed the rest of the developed world onto an accelerated path towards the same outcome. Now obviously this is an oversimplification as each country’s economy is structurally different, but the broader point is still valid: given the demographic trends and current debt levels, developed countries are likely to see low GDP growth rates for a while.

In the US in particular, Trump pulled a significant amount of future GDP growth to the present by running one of the largest peace-time fiscal deficits in US history. But that game may now be coming to an end as debt levels approach extremes. The US will be coming out of this crisis with 130%+ debt-to-GDP at the federal level. Just as a reference, Greece was at 160% when it had to be bailed out by the IMF.

How long will investors continue to buy US Treasuries at rock-bottom interest rates to fund the never-ending deficits? Central banks all over the world have already been diversifying their holdings away from US Treasuries to other assets such as gold. Recently, the Fed has had to step into money markets due to liquidity issues being caused by the sheer volume of treasuries being issued.

The lesson from Japan is that when you have high debt levels and low growth, getting creative with monetary and fiscal policy doesn’t usually help. Japan tried 40 different monetary and fiscal programs over the last few decades that all failed to produce meaningful growth. Growth in Japan has been so low for so long that it has undermined their demographics and impacted their culture and national mindsets in permanent ways.

History teaches us that there are only three ways to get out of this type of a debt deflationary scenario:

1. Step change in technology and productivity (least painful)
2. Demographic boom (takes time)
3. Combination of mass defaults and mass austerity (most painful)

There are historical examples to illustrate this.

In the 1860s and 70s there was a huge debt build up because of the building of rail roads. There was land speculation, stock market speculation, overconsumption. There was also no central bank and no Keynesian economics, so the government only cared about balancing the budget (rather than providing fiscal stimulus). The result was a period of massive defaults and austerity (#3) which took 20 years to recover.

Post World War II, the US was luckier. There was a huge post-war debt burden but a combination of #1 and #2 (above) helped the economy recover and manage the debt without too much pain. The men who were away at war came back and the baby-boomer generation was born, which was a huge demographic dividend. The US also invented a number of new technologies which raised worker productivity at historic rates. US exports to the rest of the world surged as most US allies were war zones that desperately needed goods and US technology to rebuild.

Demographics are hard to change in the short to medium term and forcing the issue can lead to unintended consequences (e.g. China). Major technological shifts are impossible to predict as they happen with irregularity. In today’s world, this leaves #3 as the most likely outcome. 

It seems like Japan wanted to defy the laws of economics and go beyond these three solutions by printing nearly unlimited amounts of money and issuing nearly unlimited amounts of federal debt. Had it done nothing and simply allowed defaults / cleaning up of balance sheets in an orderly fashion, perhaps they could have returned to growth quicker?

What About Hyperinflation?

If the central banks get overly creative and decide to conduct MMT (Modern Monetary Theory) in response to deflationary risks, then we could get hyperinflation. MMT would basically involve the central bank liabilities becoming legal tender and the decision to fund govt. deficits with money printing.

This would happen if investors refused to buy more US Treasuries. The US govt. would then choose to default indirectly through MMT (paying back it’s debts with worthless paper) rather than default directly (i.e. stop paying interest on it’s debt or defaulting on its obligations on things like social security, Medicare / Medicaid etc.).

In a way quantitative easing is similar, but the distinction is that the Fed still claims to be buying securities in the ‘secondary markets’ and supporting ‘liquidity’, not financing govt. deficits / monetizing debts. If / when the Federal Reserve Act is changed and the Fed moves to MMT, then we should get strong inflationary pressures in short order.

In such a scenario, stocks may do well initially as the market will be optimistic in light of the unlimited amount of liquidity (i.e. ‘helicopter money’). But eventually, as people wake up to the realization that paper money is worthless and that the government is implicitly defaulting on it’s obligations, there will be huge wealth destruction. People will shun fiat currency and start conducting trade and economic activity outside of the fiat / credit system. This would be a return to a barter economy as we saw in hyperinflationary episodes in Germany in 1920s, China in 1930s (there are several other examples).

The Path Forward

The road ahead is fraught with risk, and now is the time to be cautious.

Gold seems like a pretty good bet as it should do ok in most scenarios:

If we get a V-shaped or U-shaped recovery, then gold will do fine. It’s a simple supply / demand issue. Demand for gold is rising as central banks diversify away from US treasuries to holding more gold. Individual gold demand is also on the rise (India and China in particular) as gold remains extremely under-owned in most people’s portfolio of assets.

Gold is also the best hedge against hyperinflation and a collapse of the fiat system as it has historically been considered a safe store of value. If we get a financial collapse and governments, corporates and banks start defaulting, then gold will do extremely well as it lies outside of the credit and banking system.

Gold has also historically done extremely well in deflationary environments, increasing it’s purchasing power relative to other assets.

Now more than ever, it makes sense to hold at least 10 – 15% of one’s net worth in gold. The safest way to own it is through buying the physical asset (bars, coins). Next safest is to buy an ETF like GLD. For investors willing to go further up the risk spectrum, gold miners can be a good bet as the sector remains unloved and deeply undervalued relative to the potential upside in a gold bull market scenario.

A Word On Oil

Finally, the energy sector will do extremely well going forward. As I’ve written countless times on this blog, there has been a severe under-investment in conventional energy over the past 5-6 years, thanks largely to US Shale. The flaws in the US shale model had already started becoming apparent in 2018 – 2019 and we were seeing massive capital outflows from the US E&P sector.

The coronavirus has accelerated the process and is the final nail in the coffin. With oil prices at < $0 at some of the US basins, companies can’t shut in wells fast enough (when your gross margin goes negative, you lose more the more you produce). A string of bankruptcies is around the corner and the stage is set for massive consolidation.

Financially ruined by decades of cash flow burning operations, investors are going to set a high bar for the US E&P industry to gain access to fresh capital post-crisis. The ‘growth at all costs’ model for US oil and gas producers is going to be remembered as one of the greatest value destruction phenomena in the history of US capitalism.

This means production will be structurally lower by several million barrels per day going forward. The US E&P companies that do survive will consolidate assets, reduce costs, reduce leverage and focus on free cash flow rather than production growth.

This combined with global under-investment in conventional resources is going to push oil supplies to a tipping point. With so much production being shut in globally, we are now far past the ‘cutting fat’ phase and deep into the ‘cutting muscle’ phase. Even if demand never fully recovers to the 2019 levels, we are doing so much structural damage to supplies that the seeds of the next bull market in oil have been firmly sown.

It has been a torturous journey as an oil investor over the past few years, but I believe we are only a few more feet of digging away from hitting the treasure chest. Now is not the time to give up.

Uncharted Waters

In 1800, a German philosopher Johann Gottlieb Fichte wrote: “you could not remove a single grain of sand from its place without thereby … changing something throughout all parts of the immeasurable whole”. He was referring to what is commonly referred to as the ‘Butterfly Effect’; the idea that small changes in the initial conditions of a deterministic non-linear system can lead to large changes in the end state. The famous metaphor for this behavior is a butterfly flapping its wings in China can cause a hurricane in Texas.

Most people suspect that the Coronavirus (COVID-19) was transferred from animal to human some time in 2019, somewhere in China. A small change in a single human’s biological state in 2019 has turned the entire world upside down in a few months.

As the number of cases outside of China continues to grow exponentially, it’s pretty clear to me that there are only two (both painful) choices available: a) ‘flatten the curve’ of infection and suffer severe economic pain or b) let the infection run it’s course until we discover a vaccine or develop herd immunity, and let millions of people die.

Most countries (e.g. Italy) started with approach ‘b’, not realizing that even a small % mortality rate can mean an astounding number of deaths. People are generally bad at extrapolating exponential trends, and most countries didn’t fully grasp that if left unchecked, ~50%+ of the population can become infected in a matter of months.

As the chart below makes it clear, the same percentage increase in cases means that the number of new cases is going to continue to grow exponentially:

 

 

Looking at this chart with a log scale makes this easier to visualize:

 

 

There are a number of factors that make this disease particularly infectious:

1. The virus can remain airborne for up to 3 hours. So if someone sneezes / coughs, anyone passing through and breathing the air over the next three hours is likely to get infected
2. The virus can survive on surfaces in droplets for 24 – 72 hours
3. On average, 80% of infected individuals are asymptomatic / suffer mild symptoms
4. Due to the lack of testing kits available and the lack of severe symptoms for a significant majority of infected individuals, it’s estimated that ~86% of cases are going unreported
5. Unreported cases, particularly younger people (including children) that often show little / no symptoms, are probably the major cause of the infection spreading

As a result of points 1-5 above two things are absolutely essential to get the situation under control:

1. Putting strict social distancing / self-isolating measures in place to reduce transmission. This will flatten the curve, pushing the peak number of cases out until the healthcare system is better prepared, and also reducing the magnitude of the peak  / peak burden on the healthcare system
2. Do everything possible to get mass testing in place so that the % of unreported cases is reduced drastically

Most of the developed world is coming to this realization and has started executing on point #1. Without social distancing, the mortality will be truly astounding. Simply isolating cases and shutting down schools / universities will not be enough (source: https://www.imperial.ac.uk/media/imperial-college/medicine/sph/ide/gida-fellowships/Imperial-College-COVID19-NPI-modelling-16-03-2020.pdf):

 

 

With social distancing, mortality will still be significant but we can buy ourselves more time and flatten the curve a lot more:

 

 

(Note: some prominent people including Bill Gates have argued that the assumptions used by the Imperial paper are too extreme / pessimistic; I’m not qualified to comment on this but I think the charts are directionally correct on the relative impact / outcome of social distancing)

I also hope that there is appropriate time, energy, resources being invested in #2. If we can send a testing kit / swab to every household and manage to test 90%+ of the population, we can then quickly identify infected people and self-isolate them. This would allow the economy to restart sooner as non-infected people can come back to work. I’ve also read some proposals of sending mobile alerts to anyone who has been in the vicinity of an infected individual during the time they were contagious:

 

 

In the absence of strategies to address #2, we will have to rely on #1 for longer which will pull the global economy into a slowdown unlike anything we’ve seen for the past 50+ years. I think that the economic impacts of social distancing are being underestimated. ~90%+ of businesses in North America are small / medium sized businesses with limited access to liquidity and they simply can’t afford an extended shutdown. Goldman is the only sell side firm that seems to have put out a realistic set of GDP numbers, showing Q2 GDP contracting ~25% YoY:

 

 

If we are not able to get our house in order on point #2, then the resulting economic devastation will have several unintended consequences including mental health issues, civil unrest, political instability etc.  The govt. will be forced to flood the economy with unprecedented amounts of fiscal and monetary stimulus at a time when central bank balance sheets are already bloated, and fiscal deficits and debt levels are at historic highs.

In my last blog post I wrote that this could all be over in 3 – 6 months and that while the impact on the economy may match the 2008 / 09 recession, it would also likely be over sooner due to the lack of a credit crisis. I might have been too sanguine in my assessment.

While it’s true that the banking system in North America is a lot better capitalized vs. 2008 / 09, there is simply no precedent for the entire economy shutting down. In the absence of mass testing, we could enter into a vicious circle of secondary outbreaks and secondary waves of social distancing which could prolong the economic slowdown for more than a year (or until a vaccine can be developed for mass distribution). The rest of the world may struggle even more given their lack of resources which means that even if the developed world can bring the situation under control, the global economy could continue to struggle for a while.

We are headed into uncharted waters on several fronts. While it makes sense to deploy some capital now for the long-term, it’s also important to also keep cash on the sidelines and monitor how the situation plays out.

Thoughts on Coronavirus

Last week saw one of the steepest plunges in stock market history as investors finally woke up to the risk of the Coronavirus becoming a global pandemic.

I find this a bit funny, because even a cursory glance at the situation developing in China over the past few weeks would have led any reasonably astute analyst to conclude that this was going to be a global issue. But as is often the case in secular bull markets, investors found countless reasons to downplay the risks and justify their long positions.

The most commonly heard take: “it’s just like the flu” was really another way of saying “it’s not my problem (until, of course, it’s in my backyard)”, because that line of reasoning doesn’t stand up to even 2 seconds of logical analysis.

The key risk with Coronavirus has never been the mortality rates (even though they are 10-20x higher than the regular flu), but rather the logistics and economic impact. For example, the increased load on hospitals (in addition to the base load) is something most healthcare systems are not equipped to handle. In the US there are only 925K beds TOTAL. That’s before we get into staffing related issues.

In the US, testing kits are only now getting distributed broadly. This combined with the fact that most infected persons are asymptomatic for up to two weeks means that there has likely been rapid transmission in densely populated areas already. The number of cases in the US should explode in the coming weeks. Even 0.5%-1% of Americans getting very sick through the Coronavirus would be a nightmare for hospitals, businesses etc.

The supply chain impact is also important to think through. We live in an interconnected world with extremely complex supply chains that are only as strong as the weakest link. The loss of supply of even a single part in a 100+ part production line can grind the entire operation to a halt. According to the latest PMI data, supplier delivery times all over the world are soaring because of the factory shut-downs in China. Inventories are running low.

This will only get worse as the virus spreads to other countries. In the UK, Markit reported that UK manufacturers were facing the “the largest month-on-month slide in supply chain performance since the survey began in 1992”.

As the world’s largest economy, the US will have a disproportionate impact. Work stoppages in China and the US at the same time could eviscerate the global supply chain. Many businesses could go bankrupt, leading to a vicious downward spiral of less hiring and lower spending.

The market finally woke up to these risks last week, and the washing out of sentiment was violent given the leveraged long positioning: 

 

 

From a market sentiment perspective, we have now done a one-eighty. Investors have gone from complete complacency to complete panic.

 

 

There are several ways to measure market sentiment, and this blog post does a good job of looking at these data points: https://macrocharts.blog/2020/02/28/a-historic-week-for-stocks/.

It looks like we are now as oversold as the worst sell offs in stock market history (including the 2008 GFC). For long term investors, this type of market condition is the ideal hunting grounds for bargains.

There Is No ‘Perfect Time’ To Buy

During a market downturn, the perfect time to buy is only apparent in hindsight. During the financial crisis in 2008, it was impossible to tell when the market would bottom. The S&P500 bottomed in March of 2009, but the NBER didn’t announce that the recession was over until July of that year. If you didn’t panic, and bought stocks at a measured pace over that period of time, you were able to earn a very high return on capital over the next few years.

In the current situation, it’s almost certain that there is more bad news coming and the markets will remain volatile. But it’s impossible to predict when we bottom.

If there is a global pandemic, we are likely to see a 2008/09 style recession. It’s also possible that countries are able to contain the spread more quickly, in which case the economy should rebound more quickly.

Even in the worst case scenario however, the global economic downturn will be short lived because a) it’s being driven by a temporary demand shock (not something structural like a credit bubble) and b) because the mortality rate among the working population is quite low, once the virus has spread significantly and all workers are in the same boat, the need for mass quarantines, travel bans, business shut downs etc. will be obviated.

There is also some evidence that the virus doesn’t do well in warmer weather. Countries like Singapore, Philippines, Thailand and Malaysia have all seen fairly low number of cases. The fastest transmission has been in colder climates (S. Korea, Japan, Italy etc.). This means we could see a sharp snap back in demand by the end of spring / early summer.

Regardless of which scenario plays out (it’s impossible to know), if one is willing to look 3 – 6 mos down the road we will likely be in a world of lower interest rates / looser monetary policy, higher fiscal spending, rapid inventory restocking and snap back in travel demand.

While some businesses will be permanently impaired, the vast majority will survive and be able to thrive in the post-Corona environment. However, because investors are in panic mode, they have repriced the entire market with no regard for business models, leverage, economic exposure etc.

This is the opportunity value investors wait for.

A Quick Look at CRC and Gear

My two largest positions are a great example of the kind of dislocation I described above.

I wrote a recent blog post outlining how CRC’s recently announced debt exchange could be ~$900mm / $15+ per share accretive. The company also announced its Q4 results recently; one of their joint ventures is likely to revert by the end of this year, adding $80mm to annual cash flow. This is in addition to ~$34mm of net interest savings from the debt exchange. So ~$114mm in additional FCF at a current market cap of $374mm!

Gear Energy is currently trading at a 70% discount to proved reserve NAV of C$0.84 and even producing NAV of C$0.33 (these are net of debt and decommissioning liabilities). In 2019 the company generated ~C$62mm in FFO and spent ~C$37mm in capex. Their capital plan for 2020 is ~C$50mm. A company that is planning on spending C$50mm in capex over the year and generated C$25mm of free cash flow, is trading at a market cap of C$60mm.

While oil demand is likely to contract meaningfully in the first half of this year, the rational investor will take a step back and realize that as long as the world doesn’t come to an end, we will still need oil for our day-to-day activities and that demand will eventually rebound sharply.

Offsetting the impact of the demand contraction is a ~1mm b/d outage from Libya, slowing US Shale production, and a 1mm b/d+ additional cut likely to be announced by OPEC this week. These should support oil prices in the near to medium term.

In the longer-term we have more serious supply issues as I’ve described in the ‘End Game’ series.

Conclusion

When the market panics and most investors are gripped by scary headlines, the rational value investor goes to work. No one can time the bottom, and the market may go down further from here. But the panic has already pushed a number of businesses deep below their long-term intrinsic value, offering a margin of safety that is rarely on offer. It’s important to remember that you never get a good bargain when the outlook is good. The time to start buying is now.