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The US shale oil boom has been one of the big economic stories of the past decade, reversing what many thought was an inexorable decline and transforming America into the world’s biggest oil producer. But that progress hasn’t translated into big market returns for US Energy firms. Perhaps counterintuitively, while production boomed in the last decade, Energy stocks sagged. In our view, this shows one seemingly big economic positive doesn’t necessarily translate into hot market returns. We also think it shows the dangers of presuming the recent past predicts the future—something investors should keep in mind when weighing what to do with Energy from here.
To understand the US Energy renaissance story, look first to oil prices in 2000’s first decade. Here is a chart.
Exhibit 1: Oil Prices Popped in the 2000s
Source: Federal Reserve Bank of St. Louis, Crude Oil Prices: West Texas Intermediate (WTI) – Cushing Oklahoma, daily, 12/31/2000 – 12/31/2010.
This week, the US Treasury dropped its official designation of China as a currency manipulator … and added Switzerland to its watch list. China’s currency manipulator status lasted all of five months, and if you believe that China started manipulating the renminbi five months ago and has now magically stopped, we have a bridge to sell you. One that will take you straight to a beachside villa in Scottsdale. But funny as the China piece of this story is, considering Chinese authorities have mostly intervened to strengthen the yuan in recent years, the Swiss angle is even funnier. The direct implications here for investors are basically nil, but we do think the saga shows why the currency manipulator designation is mostly symbolic and not very meaningful for markets.
The US Treasury says a country is a currency manipulator if the following hold true. One, it heavily intervenes in currency markets. Two, it has a big trade surplus with the US. Three, it has a high current account surplus. The presumption is that if all three are true, the country must be artificially weakening its currency to gain an unfair advantage by making its exports cheaper (and imports more expensive).
We wrote last August why including China was dubious. The evidence overwhelmingly showed Chinese officials’ primary aim since 2015 was keeping the yuan stronger. As we explained (with charts): “Back in 2015, when the yuan weakened significantly (including a shock devaluation that August), the PBOC burned through about $1 trillion in foreign exchange reserves in an effort to defend the currency—or more simply, to keep it from weakening further. This time around, as the yuan weakened over the past 18 months, they didn’t burn through reserves, but they didn’t amass them either. If there were a deliberate effort to weaken the yuan, we would expect China’s forex reserves to jump.” We also noted that for several weeks in mid-2019, the yuan stayed suspiciously stable even as the dollar strengthened against a trade-weighted currency basket. If the yuan were trading freely, it would have weakened against the dollar alongside other currencies. Instead, it just hovered, another indication Chinese policymakers were trying to put a floor under it.
Three years ago, when Meghan Markle was a working television actress and Baby Yoda wasn’t even a glint in Lucasfilm’s eye, pundits seemed collectively sure of one thing: With the British pound at generational lows following the Brexit vote, inflation was sure to skyrocket and torpedo the UK’s economic expansion. As CPI inched up in late 2016 and 2017, the coverage got steadily noisier, and we risked running out of creative ways (and charts!) to explain why the fear was likely overblown. So it was with a smirk and a chuckle that we greeted Wednesday’s big non-Megxit UK news that inflation hit … wait for it … a three-year low in December. At just 1.3% y/y, headline CPI is now below most central banks’ inflation targets. Not to say we told you so, but chalk this up as yet another example of why investors shouldn’t accept headline fears at face value.
The logic behind expecting higher inflation after the pound plunged, at a surface level, was sound enough. When your currency weakens, it can raise the price of imported goods, presuming exporters want to preserve their own profit margins and demand at home is strong enough to support a price increase. The UK imports a ton of food and consumer products. But as we explained at the time, extrapolating this to perma-high inflation seemed wrong. For one, Japan’s recent experience proved currency fluctuations affect export prices much less than people presume. Two, the CPI basket includes goods and services, which are more insulated from currency movements. Three, the inflation rate is the year-over-year change in the CPI index. So even if the pound stayed at 2016’s lows, the impact on prices wasn’t likely to last much longer than a year, as the weaker pound would soon be part of the new baseline. Back in 2011, CPI topped 5% briefly, alongside a weak pound. Prices started easing long before the pound enjoyed a sustained recovery. It was simple math.
That is largely how things played out. The headline inflation rate peaked at 3.1% y/y in November 2017, then began a fitful slide to December’s 1.3%. Excluding energy and seasonal food, “core” inflation peaked at 2.9% in November 2017 and finished 2019 at 1.4%. Note that this improvement occurred even though the pound retested its lows last summer and is still quite a bit weaker than before the Brexit vote.
A year ago, markets were just a couple weeks removed from stocks’ second-worst December on record. Uncertainty reigned. Investor sentiment was down in the dumps, with many fearing a bear market and recession loomed. We now know that wasn’t the case and, after 2019’s gangbusters returns, sentiment seems more sanguine. But the euphoria that frequently accompanies bull market peaks looks a ways off yet—suggesting to us stocks have further to climb.
Sentiment, on its own, isn’t a leading indicator. But stocks do move on the gap between reality and expectations—a sentiment byproduct. If investors expect disaster, even a mediocre reality is bullish. On the flipside, when investors run out of worries, they may miss big fundamental negatives—a potentially bull-ending combination. But for all its importance, gauging sentiment is more art than science. Surveys trying to capture it aren’t airtight, and actions often speak louder than words. So assessing sentiment requires looking at a range of indicators. In our view, these presently reveal a mixed bag of measured optimism and lingering skepticism.
First up: some surveys. The Conference Board’s consumer confidence gauge hit an 18-year high in October 2018 before retreating some as the Q4 correction struck—logical, as folks’ feelings typically fluctuate with economic and market conditions. It has bounced around that level ever since, indicating US consumers aren’t letting the lengthy expansion get them overly cheerful.
After US drone strikes at a Baghdad airport Friday killed the general in charge of Iran’s elite forces, speculation is swirling over whether the situation will escalate. In response, early Wednesday local time, Iran launched missile strikes on US bases in Iraq. There were no reported casualties, which some believe was intentional on Iran’s part and opens the door to a climbdown in tensions. However, that is unknowable. Concern is palpable, which is understandable given the potential destruction and loss of life. But there is also significant speculation about what potential escalation may mean for stocks—with some fearing negative fallout. Yet markets are no stranger to geopolitical risks. For investors, knowing how markets typically respond to such events is critical for investment decision making.
This incident is the latest in escalating tensions between Iran-backed militia groups and the US military. American officials blame Iran for an assault on the US embassy in Baghdad on December 31 and New Year’s Day, which Iran-backed groups say was a response to American airstrikes on militia groups. The US alleges its strike that killed Qassem Soleimani, the Iranian commander who allegedly orchestrated proxy conflicts across the Middle East, was to preempt further attacks. Yet many worry this will do the opposite, potentially spurring outright war between the US and Iran. Both sides have issued a variety of threats to military targets. America has threatened to ratchet sanctions up further. Iran claims it could block the Strait of Hormuz, a major chokepoint for shipping from the oil-rich Persian Gulf.
US tensions with Iran aren’t new or terribly surprising, especially following the US’s withdrawal from the Iran nuclear deal last year and imposition of strict economic sanctions. Iran and its proxies have been heavily involved in Iraq and the rest of the Middle East for some time as well. There is also precedent for Iran’s threats to block oil supplies. Last May and June, Iran allegedly attacked oil tankers in the Strait of Hormuz. It actively seized some during the summer. But the effect on oil prices was brief, which seems pretty rational to us. During 1980s’ Iran-Iraq war, when combatants sought to sink each other’s tankers, they stopped only 2% of oil traffic. As for other means of blocking supply, in September, Iran-backed militants used drone attacks to shut down 50% of Saudi Arabian production—a direct attack against oil infrastructure. But facilities were back online within days. Despite major disruptions—and apocalyptic press coverage—volatility was fleeting; oil markets returned rapidly to normal.
Editors’ Note: Our political analysis is intentionally non-partisan. We favor no political party or candidate in any country and assess political developments solely for their potential economic or market impact.
326 days. That is how long it has been since Spain’s last government collapsed. Two elections and a lot of horse trading later, they finally have a new one: a minority coalition between Prime Minister Pedro Sánchez’s center-left Socialist Party and the leftist populist Podemos. On the bright side, this eases a year of political uncertainty, but investors aren’t cheering. Rather, pundits are dissecting the ruling parties’ campaign pledges and fearing the worst for Spanish stocks—especially banks, which have struggled lately. Yet given the coalition is likely powerless to accomplish much, we think reality should prove much better than feared, helping Spanish bank stocks improve.
It isn’t hard to see why investors are nervous, as the incoming government has made some rather radical pledges. In addition to partially rolling back prior governments’ labor market and pension reforms—undertaken during the eurozone sovereign debt crisis—they have proposed jacking up income and capital gains taxes, setting minimum corporate tax rates (with higher minimum rates for banks and energy firms) and implementing a limited financial transactions tax and more.[i] We suspect this has a lot to do with Spanish banks’ diverging fortunes from the rest of Europe this year, considering bank taxes have been in the Socialists’ manifestos for both elections. Since April 26—the market close before the indecisive April 28 election—Spanish banks have declined -8.5%. [ii] Meanwhile, French and Italian banks, are up 17.8% and 8.4%, respectively.[iii]
Today is New Year’s Eve, and barring a late-day collapse, the S&P 500 is on course to top 30% for the year and log its best calendar-year return since 2013. The MSCI World Index, meanwhile, looks set to notch its second-highest annual return of this bull market, trailing only 2009’s initial surge. As is usual this time of year, the year-in-review retrospectives are rolling in, with most crediting Fed rate cuts and trade war U-turns for these gobsmacking returns. We don’t think so. Please allow us to set the record straight.
To say rate cuts and eased trade tensions drove this year’s returns is to ignore the year’s timeline. The Fed didn’t start cutting rates until July 31. President Trump and China didn’t start zeroing in on a phase one trade deal until autumn. As late as October, both sides were still planning to ratchet up tariffs. Meanwhile, when US markets closed on July 31, the S&P 500 was already up 21.6% on the year.[i] We get that stocks are forward-looking, but even then, crediting future rate cuts and unpredictable tariff rollbacks seems like a bridge too far. Something else was going on, in our view.
To us, that something else was the rebound from stocks’ bloodbath in December 2018, which capped a correction (a sharp, sentiment-driven pullback of around -10% to -20%) that began last September. The steep decline had most convinced this longest-ever bull market was doomed and a recession all but assured, lowering expectations dramatically—and setting the stage for a big rebound if reality proved less dire. As we now know, no 2019 recession struck. The bull market persisted. Pessimists got a positive surprise.
In markets, widely watched and well-known events routinely underwhelm. On this final day of 2019, the repurchase agreement (repo) market taught this lesson once again … by doing next to nothing noteworthy. That likely comes as a surprise to many pundits who have been obsessing over short-term interest rates for months. But to us, it is the highly predictable outcome of the Fed returning to what it routinely did for decades before its wrongheaded quantitative easing (QE).
This story starts back in September, when repo rates—which typically hover right around the middle of the fed-funds target range—surged. The repo market is where banks lend excess reserves to one another against high-quality collateral, like short-term Treasurys. As we wrote in our September ‘splainer, banks’ reserves occasionally dip below regulatory minimums for short periods of time. (This is normal!) When they do so, banks typically seek to borrow from one another or big investors, like money market funds.
History’s longest bull market hit a fun little milestone this week, when the S&P 500’s return with dividends crossed 500% on Wednesday and … no one noticed. On the surface, this shows three things. One: People aren’t looking for round numbers to hype—another sign sentiment remains in check. Two: Lots of finance reporters are on holiday break. Three: Most people probably look at price returns, which exclude dividends. Two of those three could be articles in their own right, but we found another angle slightly more fascinating and more helpful on a forward-looking basis.
Ever since the S&P 500 price index recaptured its October 2007 high in 2013, people have questioned how much further the bull could run.[i] Folks thought stocks had come too far, too fast after 2013 delivered a 32.4% total return.[ii] Investors have routinely feared the bull running out of gas ever since—during rallies and pullbacks alike. But the tank was far from empty, and now this bull is the second in modern history to punch through 500%—trailing only the 1990s’ bull in magnitude. (But exceeding it in length, highlighting what a grind it has been at times.) All those past milestones weren’t significant or predictive. They didn’t tell you anything about what came next, just as this one doesn’t.
The eye-popping cumulative return also shows the power of compounding. As Exhibit 1 shows, after the initial bounce, annual returns during this bull market weren’t exactly off the chart. Several were actually kinda blah.
The Fed’s meeting made news as usual earlier this month, but for once its interest rate decision (keeping its fed-funds target range at 1.50% – 1.75%) wasn’t the big story. Nor was the infamous dot plot’s projection of no rate moves in 2020. Rather, to us the big news was Fed people questioning the dot plot’s usefulness in the first place. When asked, Fed head Jerome Powell said, “I think properly understood, it can be useful but ... if you focus too much on the dots, you can miss the broader picture.” Some piled on, arguing the dot plot should be scrapped. Others agreed with Powell: Take Fed dot plots in context—and skeptically. We find this debate encouraging, as we have long questioned why people focus so much on a report that isn’t even an attempt to forecast the Fed’s decisions. In our view, the more investors understand its limitations and stop seeing it as a divining rod, the better off they will be.
We now have eight years of history to judge the Fed’s dot plots, which show each Fed person’s prediction of the “projected appropriate monetary policy path.” While they occasionally form fun shapes and pictures,[i] their record of predicting Fed action is spotty.
Exhibit 1: The Dot Plot Doesn’t Foretell Policy
Source: Federal Reserve, as of 12/12/2019. Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, December 2011 – December 2019.