Category Archives: Global Economy

Global Economy

Are You Prepared For The End Of The Bond Bubble?

Global Economy, On the cover, Sin categoría

The biggest bubble in financial history is about to end.

With rate hikes, a stronger dollar and the return of inflation, bond inflows are normalizing, sell-off in negative yield fixed income continues, and real rates increase despite central planners’ financial repression. High-yield bond funds saw their biggest outflows since December 2014 last week, as investors withdrew $5.7bn, according to EPFR Global.

Meanwhile, the total value of negative-yielding sovereign bonds fell to $8.6 trillion as of March 1 from $9.1 trillion at the end of 2016.

Three factors are helping the burst of the bond bubble:

  1. The price of oil falling to three-month lows on the evidence of the ineffectiveness of OPEC cuts, a record increase in inventories and a stronger dollar is helping to reduce the thirst for high-yield.
  2. A strong “America First” policy needs a stronger US dollar. The US economy benefits from a strong dollar and rising rates, not the other way around. Believing that the US needs to weaken its currency is a fallacy repeated by mainstream economists. The US exports are relatively small, about 13% of its GDP, and its citizens have 80% of their wealth in deposits. The new administration knows it. They are their voters. The only ones that benefit from a weak dollar and low rates are bubbles, indebted and inefficient sectors. If a rise in rates of 0.25% negatively impacts a part of the economy, after more than 600 rate cuts, it means that such part of the economy is unsustainable. Increasing rates is essential to limit the exponential growth of bubbles and excesses.
  3. The European Central Bank. The placebo effect of ECB policy has already passed. With more than € 1.3 trillion in excess liquidity and a dangerous environment where economic agents have become “used” to unsustainable rates to perpetuate low productivity sectors, it is inevitable that the central bank will begin to unwind its Monetary laughing gas sooner rather than later.

That dollar strength and US rate hikes, reinforced by the Trump administration’s capital repatriation policy, is exactly what the country needs if it really wants to “make America great again.” If you destroy the middle class with financial repression, you will not only lose its political support, but the policy will not work either.

Strong dollar, normalized rates and repatriation of capital create the vacuum effect. Higher demand for dollars is triggered and the attractiveness of low yield bonds outside the US is reduced.

… In Europe, we are not prepared for the bond bubble to deflate.

The vacuum effect can mean a loss of up to a $100 billion just from repatriations. If the top five technology companies repatriated half of their cash back to the US, it would mean more than $240 billion leaving the rest of the world and returning to the US.

But, moreover, rate hikes make it less attractive for investors to buy bonds from European and emerging countries.

At the moment, growth prospects in the Eurozone, and the US-European inflation differential keep the flow of investment in the European Union because in real terms it still offers a decent mix of risk and profitability. But the Eurozone has a problem when governments have to refinance more than a trillion euros and have become used to spending elsewhere the “savings” in interest expenses achieved due to artificially low rates.

 

Are You Prepared For The End Of The Bond Bubble? - z uno

 

Those savings have already been spent, and when rates rise, and it will happen, many countries do not seem to be sufficiently prepared. Same with many companies. The rise in inflation and rates, which has given some breathing air to banks, holds another side of the coin. Non-performing loans have not been adequately cleaned, and remain above 900 billion euro in the European financial system. Banks do not have enough capital cushion to undertake the deep provisions that would entail cleaning up such a hole and have relied on the recovery to try to sell these loans. The improvement in NIM (net income margin) coming from inflation and a rate increase does not compensate for the increase in NPLs and their provisions. A rate hike of 0.25% means an increase in NIMs of 17% for Eurozone banks, but the clean-up of NPLs would completely wipe out that benefit.

The European Central Bank should analyze the risk of fragility. Because it has not been reduced.

Europe continues to suffer from three factors: Industrial overcapacity, high indebtedness and excessive weight in the economy of low productivity sectors.

These sectors -industrial conglomerates, construction- have absorbed most of the new credit. The ECB and governments were too obsessed with increasing credit to the economy to worry about where that credit was going to. When Eurozone economies and companies are afraid of the impact of a hike of just 0.25%, it means we have a problem – really big.

Do you have a business? Are you prepared to pay 1-2% more for your financing in the next five years? Yes? Congratulations. You have nothing to worry about.

Do you have a variable rate mortgage? Are you prepared to pay a few hundred euros more per year in the next few years? Yes? You have no problem.

Do you have a country where net financing needs are going to continue to fall as rates rise? Yes? Congratulations, you are fine.

Do you think that the ECB will have to keep or lower rates because everyone is so entrapped that it needs to be more dovish? I wish you luck.

The big mistake of central banks has been to create bubbles, then deny them, and afterward try to perpetuate them with the same policy that created the initial problem. Lowering rates and increasing liquidity has been the only policy.

Now central banks face a new US administration that sees currency wars and beggar-thy-neighbor policies as what they are, assaults on the middle class. Financial repression did not work in the past, and failing to adapt economies to normalized rates is dangerous.

Investors should really pay attention because real and nominal losses are more than evident in bond portfolios.

EDITOR’S NOTE

This is a Hedgeye Guest Contributor note written by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the forthcoming Escape from the Central Bank Trap.

Courtesy @Hedgeye

Op-Ed at CNBC: “Cut and dried? Oil prices are entering a bearish trend despite supply deal”

Energy, Global Economy, On the cover, Sin categoría

Oil prices have entered a bearish trend despite short-term bounces, supply cuts and improved demand estimates.

The lateral range of $50-$55 a barrel was recently broken, with the new long-term support level for Brent edging closer to $45-$47 rather than $50 a barrel. With money managers’ net length exposure to crude prices at the highest level in months, the risks for oil prices seem tilted to the downside.

There are various reasons for this trend.

The supply cut deal struck between members of the oil-producing cartel OPEC and non-members is ineffective and under question. We read everywhere that compliance is 90 percent, but Saudi Arabia is, in reality, the only member that is reducing output by a lot more than agreed according to OPEC figures (130,000 barrels per day cut above its agreed production), while Russia is at almost at a third (118,000 b/d versus the agreed 300,000 b/d).

Meanwhile Emirates, Kuwait, Venezuela, Algeria and others are between 50 percent and 60 percent compliance on the agreed cuts. Only Angola is cutting more than announced. This reliance on Saudi Arabia doing all the work is dangerous. Saudi Arabia has already announced it will increase output above 10 million barrels per day in February.

 

Iran keeps pumping out oil at record levels and Iraq is increasing its output to multiyear highs. Oil exports from Iran in February reached 3 million b/d, a level not seen since 1979. According to the International Energy Agency, Iraq will increase its output to 5.4 million b/d by 2022. Similarly, Iran is expected to boost production to reach 4.15 million b/d in 2022. These barrels are of high quality and abundant, as reserves have been underdeveloped for years.

Additionally, U.S. production is rising faster than expected. U.S. oil production has increased by 400,000 b/d from the lows, according to the IEA, surprising consensus that thought that shale would not recover before Brent reached $65 a barrel. Shale breakeven is now at the high $30s-low $40 a barrel level, and OPEC has underestimated the strengthening balance sheets and improvement of efficiency seen in U.S. companies. The U.S. is on track to deliver a 1 million barrels per day increase in production from December 2016 to December 2017, according to IEA estimates. This is before any tax cuts from the new administration, which would lower the breakeven price even further.

Despite cuts, inventories remain elevated. At 66 days of supply, OECD inventories are at a six-year high compared to 55 days in January 2011, and 287 million barrels above the five-year average. U.S. crude inventories are close to record highs as well, as shown in the Energy Information Administration (EIA) data.

The main element that analysts skip is that the so-called “lack of investment” is just the burst of a bubble. While many point to capex cuts as the driver of a new super-cycle, few seem to understand that the increase seen in oil and gas investments from 2004 to 2013 was created by the bubble of low interest rates and perception of ever-rising oil prices, not by demand. Capex multiplied in real terms to more than $1 trillion per annum in a decade of excess, creating a structural overcapacity.

While demand growth has been healthy year-to-date, consensus estimates seem too optimistic. International agencies get used to correlations of growth and oil demand that simply do not work and have been broken for years. Efficiency, technology and substitution continue to improve exponentially. This technology and substitution did not stop due to low oil prices, as OPEC expected. Solar, wind, electric vehicles and other alternatives continue to thrive despite lower fossil fuel prices.

Let us also remember that a stronger U.S. dollar and the Trump administration’s “America First” policy destroy the geopolitical premium attached to the oil price. The U.S. can become fully energy independent by 2019, and a monetary policy that finally normalizes rates and supports a strong dollar has an impact on the price of a barrel, which trades U.S. dollars.

The fact that oil prices remain in a bearish trend despite the largest cut in history and money managers’ net long exposure to crude at 10-month highs, shows us that the market is not only very well supplied. It remains oversupplied. Bulls maintain that the market will be balanced in six months. They said the same six months ago.

OPEC and oil producers should focus on being a competitive, flexible and reliable suppliers. Further cuts will only weaken their position.

Daniel Lacalle is a PhD, economist and fund manager, author of “Life In the Financial Markets” and (with D Parilla) “The Energy World Is Flat”. You can follow Daniel on Twitter @dlacalle_IA

Video Interview: Secrets of a Fund Manager, Economist and Author

Global Economy, Interviews, Media, On the cover, Sin categoría

In this interview we explore my views on the economy, technology, Bitcoin, my forthcoming book “Escape from the Central Bank Trap” and many other things. I hope you like it.

Thanks for watching!

 

Daniel Lacalle. PhD in Economics and author of “Life in the Financial Markets”, “The Energy World Is Flat” (Wiley) and forthcoming “Escape from the Central Bank Trap”.

Image courtesy Google

 

The Oil Sector Underperformance Goes Beyond Oil Prices

Energy, Global Economy, On the cover, Sin categoría

So far this year, the European energy sector (SXEP Index) is the worst performing one in the European stock market. Same with Energy vs the US all-time-high levels.

The fact that this situation happens while oil prices remain within the range of $ 50-55 a barrel, shows that the sector is very far from regaining momentum after a rather technical rebound seen in 2016.

We should not forget that the oil sector was already one of the worst performers in the stock market way before the oil price collapse. The reasons were obvious. Monstrous investment plans with very poor returns, disappointing growth, weak profitability and missing companies’ own targets, added to an unsustainable dividend yield even at $ 100 a barrel.

No, the problems of the oil sector do not come only from the price of oil or natural gas. It comes from the atrocious allocation of capital and the inexorable destruction of value of many conglomerates that hide under the “long-term strategy” excuse, and the detestable “integrated model” to mask a very low competitiveness and a poor identity of objectives with the suffering shareholder who, year after year, looks to the sky and hopes that “in the long-term” things will improve.

When prices are high, the sector embarks on questionable acquisitions and, when oil prices fall, it is the shareholder who suffers.

It all started many years ago. Already in the late 1990s, the vast majority of integrated oil companies forgot the historical principles of the sector.  They forgot ROCE (return on capital employed) as a fundamental measure to analyze investments, launched “diversification” strategies that have destroyed billions of market capitalization, began to relax their investment criteria … And the disaster was slowly brewing. A sector that generated 12% ROCE at $ 14 a barrel … went on to generate a lower profitability, 11%, at $ 130 (SXEP Index).

When I started working in the oil sector, planning was made using commodity prices that were much lower than the curve. Today, oil companies’ strategy departments are semi-religious centers dedicated to praying for the price of oil to rise, resorting to conspiracy theories and hopes of OPEC cuts, instead of planning at the low-end of the cycle, as the sector always did.

US companies learned this lesson years ago when they made strategic mistakes because they thought the price of natural gas “could not fall.” Acquisitions were made in the US that required $ 6/mmbtu. But natural gas prices plummeted to $ 2/mmbtu. A reality slap in the face that led companies to go back to basics. Put ROCE in the forefront of strategies and forget the mirage of high debt. Massive capital increases, cuts in capex and restructurings ensued.

Meanwhile, in Europe, big oil companies were launching a strategy of running to stand still. Adding debt, and investing in power and renewables.

To think that the problem of the European oil sector, of its lack of investment rigor and poor shareholder return, is going to be solved with higher crude prices, is to deny reality. Investments have already started to increase – an annualized 8% – even though balance sheets remain damaged and the enormous overcapacity created in the bubble period has not been reduced.

There are opportunities in the oil sector, but I fear they are not clearly defined in Europe. Any hint of hope in European conglomerate valuations requires an act of faith, while in the US, at least the investor has managers who are aligned with investors’ interests and better fundamentals.

If investors believe that oil prices will rise, there are better options in service companies that benefit from the return of investment plans or focused exploration and production companies, where one does not have to take believe in conglomerates. In any case, despite the OPEC “agreement”, crude oil does not easily move out of its lateral range, due to the obvious excess of supply.

The high dividend yield of integrated conglomerates is an indicator that should be carefully analyzed. When those dividends are unsustainable, paid with debt or, worse, with shares, a high dividend yield could be misleading.

I do not like oil conglomerates. They are value traps by the book. They always seem optically “cheap”, but their low multiples are justified by the atrocious profitability, lack of investment rigor and megalomaniac strategic decisions.

The two trends that do interest me are the return of capex, which benefits service companies, and the energy independence of the US, which benefits the focused North American producers. The rest, with all due respect, need to stop hiding under the long-term excuse, do their homework and carry out an exercise of self-criticism and restructuring after decades of empire-building with shareholders’ money. The electricity sector did it. The integrated oil sector, like many banks, continues to believe in unicorns.

Daniel Lacalle. PhD in Economics and author of “Life in the Financial Markets”, “The Energy World Is Flat” (Wiley) and forthcoming “Escape from the Central Bank Trap”.

Image courtesy Google.