Another break in my Macro View multi-part series.
Well, we got what we wanted out of OPEC. Production cuts to 32.5 M B/D but they were also able to strap on some cuts out of non-OPEC nations like Russia (330 K B/D). and even more importantly, they list the exact cuts each OPEC member will adhere to. All this takes effect January 2017. So this was about as good as we were going to get.
The Affect on the Markets on the Day
WTI is +8.6%, Western Cdn Select +13, Various Cdn junior and intermediate energy producer stocks and some OFS (oilfield services companies) +4-15%, the same company's high yield bonds +1-3%, Gold -1.3%, Nat Gas +1%.
We also think OPEC would rather remove the downside, and the upside, volatility in the oil markets and just have the price climb very slowly over time. We think this is sustainable over the medium term. Heck, part of our view was that if OPEC didn't get a deal done today...they might as well dissolve their cartel.
As I said yesterday, we have the bulk of our energy exposure in very specific, value-driven and event-driven high yield energy bonds but we also own some specific energy stocks where we feel our research has driven us to the equity component of the capital structure (remember, our Tactical Model can go anywhere and do anything...within the scope of our Investment Policy Statement...relax, we don't use derivatives...just good old fashioned stocks, bonds, prefs and converts).
Nice way to end what was a very volatile month.
I was told by a friend on the street (thanks for the nudge JL) just now to interrupt my 3-4 consecutive day blogs on Macro Views and to write one on Oil and OPEC. So here goes...
As most of you know, and certainly a lot of people in Alberta and Saskatchewan, OPEC is meeting in Vienna tomorrow (Nov 30th). This is rather significant for two reasons: 1) There has been a wild game of chicken leading up to the meeting and 2) At the current price of WTI ($~45), the outcome is highly likely to be binary...that is to say, should they not agree on production cuts for the Saudis and at least a production freeze for Iraq and Iran, the price of oil will likely drop back below $40 and into the $30's. On the upside, should they all hold hands, sing Kumbaya and agree to solid production cuts, then the price of oil could easily gravitate back to the mid-50's. Binary - $10 down, $10 up.
So far, the Saudis have come out Sunday night and said that a production cut is not necessary for oil to hit equilibrium at higher levels in mind-2017. They certainly set the stage. Then Iran and Iraq say they won't cut and they should be allowed to restore production to levels from long ago before various sanctions were put in place against them.
In Algiers in September, OPEC producers agreed to cut about 1.2mm barrels of oil per day. Both Iran and Iraq are arguing for an increase and a freeze, respectively, in their production levels. This is something that the Saudis can't seem to agree upon with Iran and Iraq. I wonder if religion has anything to do with it? Sunni vs Shia.
And the game of chicken ensues as:
And on the periphery, there are lesser OPEC Members who will just go along for the ride as well as try to mend fences, but there are also large state-sponsored, non-OPEC producers like Russia in the picture. Russia claimed this morning that they won't even attend the Vienna meeting tomorrow. Maybe Trump can convince Putin to attend? (funny, but he would have a better chance than Hillary).
How the hell OPEC maintains its current structure is anyone's guess. With the advent of North American fracking at much lower costs than traditional vertical drilling, our producers here will push a lot more supply into the market if there is a production freeze/cut. We don't see oil getting much above $60 for quite some time due to shut-in, unprofitable wells coming back on-line.
With regards to positioning, we have most of our energy exposure through high yield bonds rather than stocks. A few reasons for this: 1) We actually have access to high yield bonds with on-the-screws pricing because of the Institutional funds we manage for BNS, 2) High Yield bonds are historically less than half as volatile as their underlying stocks and 3) Most of these oil and gas producers have continued to sell equity to raise capital, which is good for their underlying high yield bonds (puts capital underneath the bonds).
We will know in less than twenty-four hours how the game of chicken played out.
I am going to write 3, maybe even 4, blogs (we'll see how busy I am which will dictate whether I am able to write them one each day consecutively, or not) on our views on macro (big picture) events around the world and how we are positioning our portfolios to match our views.
First, I will start in the East...India, to be exact.
Over the past month, India's Prime Minister, Narendra Modi, has demonetized (cancelled for legal tender...gonzo, scrapped) 500 Rupee and 1,000 Rupee notes. The chief aim of this demonetization of these specific notes is to clamp down on the "black" market in India.
One of my office-mates is married to an Indian woman so I have learned a little bit over the past month about the Indian economy. The first thing to learn is that...it is extremely corrupt, at least from a black market point of view. There are estimates that the black market of the economy makes up 25% of India's Gross Domestic Product (GDP) but my friend Robert thinks that estimate is probably low. It is so bad there, that they have terms for their currency: 1) White Rupees and 2) Black Rupees (I leave it for you to guess which one is taxed and which one avoids tax).
It would appear the Rs500 and Rs1,000 notes are the most common notes (~C$ 10 and 20 respectively) used in the black market so stripping them out of circulation, puts pressure on the operational effect of the black market. This is Modi's idea of a movement from a cash currency economy to an electronic/digitalized economy. His hope is that it would at least help remove the further growth of the black market.
But where this might get interesting is the effect on Gold. I knew India was a society that valued gold due to jewelry demand, especially as wedding gifts. What I wasn't informed on as much was the dynamic of Indian jewelry demand, combined with safe haven demand. It is reported that India is the largest importer of gold at around 700 tonnes per year...some for jewelry, some because they want a store of value (and rightfully so, given what is happening to their currency).
And on top of that, there were rumours circulating in India last week that the next move out of Modi on his crack-down on the black market was to ban the importation of gold. That rumour was since denied (sort of) by the authorities but the price of gold in India is skyrocketing. Should they actually ban Indians from buying gold imagine what that would do to the price of gold outside of India? 700 tonnes of gold would be floating around looking for a home. I could imagine the price of gold, which has likely been getting hit over the past week or two on this potential, could possibly drop $100-200 in a day.
So to conclude our views on India and how it might affect our portfolios, we remain flat gold producers. We will keep our powder dry because if that event occurs, and for the reasons it is occurring (because a government just demonetized part of it's currency) we will want to own some gold.
It has been a good move in stocks the past two weeks but an awful move in government bonds over that same period. Time to check in and see what the S&P 500 Dividend Yield looks like vs the US 10yr Treasury Bond Yield.
First, the S&P Dividend Yield:
As you can see, it compressed very quickly. That's what happens when the dividend stays the same but the price of the market rises so rapidly. So two weeks ago we sat at 2.23% Dividend Yield and today we sit at 2.12%.
Now compare that to the 10yr US Treasury Bond Yield (apologies, Bloomberg doesn't allow me to overlay the charts):
So the 10yr US bond yield climbed from 1.80% to 2.33%. Yikes.
The obvious conclusion, with some caveats, is:
Interest rates rising so dramatically in such a short period of time has a few implications:
And also, we should have a look at the longer term trend of the US 10yr Bond: The white line is called a trend line and it goes back to 2010. We will call this a "support line" which simply means the 10yr US Treasury Bond yield "should" hold this level (at or around ~2.35%). If not, higher we go. Fundamentally, I think we will see Asset Liability Managers (ALM...life cos and pension funds) start to step in to buy US treasury bonds at these levels. Maybe when 10yrs were at 1.40% this past summer didn't help their immunization of assets to liabilities out much but at 2.35-2.50% it sure helps.
One good thing has happened over the past two weeks...the correlation between government bonds and stocks has started to perform the way it should...inversely correlated. I wrote about this in late September and it was part of the reason we sold some of our long-dated (10yr and 30yr) government of Canada bonds in early September when I noticed something wasn't quite right. Read here: highrockcapital.ca/pauls-blog/correlation-metrics Here it is today with the green shaded in the bottom panel representing inverse correlation (when stocks go up, bonds go down, and vice versa):
I hate being wishy washy and non-committal but we sit and wait. We will watch this support level in US 10yr bonds. We maintain a reasonably defensive posture but within our diversified portfolios. Although we have been under-invested in some global stock indices, we do have some very specific exposure in some Canadian equities and corporate bonds. Speaking of corporate bonds, we do have some very strategic positions in some Canadian High Yield bonds. These bonds are :"Credit" risk, not "Interest Rate" risk like government bonds so they have done quite well over the past two months that government bonds have been getting hurt. Scott wrote a bit about them here: highrockcapital.ca/scotts-blog/canadian-high-yield-bonds-a-very-good-place-to-be-invested
Have a great weekend
I won't get into the politics of what happened last night. As my Sicilian Grandfather used to say to all of his grandchildren when we asked him who he voted for, "I voted for the guy who won". Quick thoughts on the effect on our portfolios as I am seriously busy in the middle of earning's season.
First of all, Scott and I are both somewhat contrarian by nature so we were half expecting a Trump victory and our portfolios reflected that with about 30% cash. Some of our thought process was based off of the "movement" of what happened in the UK. I think the base argument for the "movement" is the 30yr old experiment, that is Free Trade, made a ton of sense from a macro economic theory about Comparative Advantage etc but what it didn't account for was small communities getting wiped out. (That and when an almost-incumbent candidate calls the other candidate's supporters "a basket of deplorables"...apparently adds support to the "movement"...funny that).
What a Trump Presidency will bring, among other changes, is less free trade around the world, less corporate taxes (15%), less regulation and huge infrastructure spending (I am not a proponent of Keynes personally).
With regards to global trade, this will ultimately be inflationary. Think about all the cheap goods the US has been buying from China...those will rise in price when they are produced in more expensive jurisdictions like Ohio.. which is the definition of inflation. Inflation is the enemy of long bonds. As I wrote in September (highrockcapital.ca/pauls-blog/correlation-metrics) we sold some of our longer-dated Government of Canada 10yr and 30yr bonds in. We took profits in early September and are glad we did because inflation is the number 1 enemy of long bonds.
Also, with regards to infrastructure spending, this too will not be good for US Government bonds as the US Treasury will need to borrow to spend like crazy. Perhaps Congress keeps him in check as will the Debt Ceiling (which can be moved higher).
For corporations, lower taxes and less regulation will be a boon for business. Maybe that is why the Dow is +61 right now as I type vs Dow Futures -870 at around midnight last night?!
As for the effect on Canada and some of our individual positions, it should be decent for some heavy oil stocks (we own one), bad for forestry (SLA and NAFTA, we own none), good for gold (we own one producer), not good for the C$ (we sold some and bought more US$ two weeks ago).. I don't have time to go thru all of my thoughts and positions but suffice to say we were positioned pretty well with about 30% cash and some strategic positions on.
We are not smart enough to say we saw this coming entirely and were 100% positioned for it but it is probably fair to say that we went into the election in pretty good shape here. Better lucky than smart...my Grandfather used to say that too. He had some other sayings and when I repeat them to my wife and three sons...their eyes roll.
We get this question a fair bit from prospective clients when we first talk to them. Of course, privacy and confidentiality rules do not allow us to give up our client names, so we talk in generalizations about what type of folks we manage money for.
I was speaking to a prospective client last week, in fact, when I was asked this very question so I thought I would write a quick post on how we describe the people we manage money for.
We can probably best-describe our clients as falling into one of two buckets:
And in group (2) we have folks who are very sophisticated investors:
But what really should matter to a prospective client is, "Will you treat me just the same as some of your larger clients or more sophisticated clients?" We get this question a lot too. You bet and, in fact, we spend less time with our sophisticated clients than we do with our less sophisticated clients (our sophisticated clients don't require a Wealth Forecast, for instance). And we promise to meet with all of our clients for semi-annual reviews, regardless of who you are or the size of your account.
And the last thing about size...it doesn't matter at High Rock. Because we are a discretionary Portfolio Management company, when we do a trade, we do it in "bulk" and then allocate it pro-rata across all of our accounts at the end of the day. So no one is disadvantaged because of the size of their account like if your non-discretionary "portfolio manager" has to call you to do a trade to get your permission...does he/she call the biggest clients first? Not sure how that works elsewhere but it is not the case at High Rock. All for one and one for all.