Friday, April 10, 2020

Commodities performance - Energy sector not the same as other commodities

No different than equity markets, commodities were hit hard with the global economic effects of COVID-19, this placed further pressure on markets suffering from over-supply. There is no worse combination than a demand shock in an environment suffering from large oversupply imbalances or excess production. However, the dispersion in returns have been huge in March and for the year. Energy markets are very different than grains or precious metals.  

Commodities are different than financial assets given that inventory builds can spread short-term market imbalances through time. Excess supply today creates contango which allow for storage to play a role in smoothing shocks; however, there are even limits to storage economics. We are reaching those limits in crude oil and refined products. There is real talk of negative oil prices. 

Investors need to go back to first commodity principles to create scenarios for this will be resolved. "Low prices are the solution to low prices." When prices reach levels where production is shut, capital finds new places to invest, and excess capacity is rationalized, prices will rise. Second, "commodities are logistics markets." An economic shock may see immediate price declines, but shocks also breaks logistics which will impact the ability to move supply to market. Prices need to rise to adjust logistical disruptions.

  • Energy markets are being fundamentally altered with the end of cheap capital for marginal producers, consolidation to stronger hands, and a reconfiguring of geopolitical oil power. The price bottom may not be with us.
  • Agriculture markets are not immune from the reworking of energy markets. The corn/ethanol/energy link is going to have to be rationalized. The same can be said for other oils and sugar used for energy.
  • Trade logistics are in upheaval. From flows across the globe, dollar invoicing, and EM capital flows for commodity development, global commodity supply chains will change and that will push prices higher. 
  • Project development will be reassessed even in an era of cheap money. Long-term projects based on poor price projections will be abandoned. Economic development will be impaired. 
  • The price and supply of labor for agriculture will cut capacity and raise prices. Migrant labor is the driver for fresh food in markets twelve months a year. 
While currently in transition, a global economy that starts to recover may make commodities a good alternative to financial assets. This is a radical change from the post Financial Crisis period. 

Thursday, April 9, 2020

Equity factor behavior in the first quarter - Consistency with macro environment

Consistency is not perfection, and long/short factor premiums will not always generate positive returns; however, as we review the first quarter, it is apparent that strategy factor behavior was fairly consistent with what was experienced in the macro environment. 

The tracking of long/short global equity factors from the Factor Research folks may not show pretty results but it tells an economic story that makes sense. Investors holding the size factor were hurt with a large negative shock. Being long small firms when there is a liquidity crunch shock is not going to be a good place for investors. Value is also not a good place to be going into a sharp recession. In contrast, quality and momentum were better places to be invested. Firms that were showing downward performance continued with that trend when the COVID-19 pandemic hit global markets. Quality investing served as a good place for safety. The low volatility factor did not offer protection after serving as the popular factor trade for a number of years.

Consistency may not offer solace for investors looking for alternative factor gains in equities. Investors would have found the protection desired by broadening the portfolio choices to other asset classes. Alternative risk premia in commodities, currencies, and rates not only provided diversification but positive returns from the pandemic shock.

Wednesday, April 8, 2020

Different types of liquidity crises - Defining the problem

Many market pundits will talk about a liquidity crisis, but they are not precise about what they mean by the term. A liquidity crisis can be broken into three different areas of focus in response to a negative economic shock. These liquidity shock alternatives will vary in strength and may resolve differently over time. This liquidity crisis breakdown may help with any discussion concerning current and future policy responses.  

A liquidity crisis will start with a negative economic shock and may follow three different liquidity shock channels: a pricing effect, an economic accounting effect, and a leverage effect. 

The pricing effect occurs when the negative economic shock impacts beliefs on pricing. If there is a strong common negative shock and expectations, there will be strong selling which can cause excess pressure to get out of markets at prices below fair value. With this forced selling buyers can only be found through giving them extra return for immediacy. This fall in price relative to fair value will be coupled with wider bid-ask spreads because dealers don't have the capital or risk appetite to warehouse assets. We have seen the impact of this pricing or market liquidity crisis in March especially with short-end rate spreads and off-the-run Treasuries. The Fed and other central banks through serving as the buyers of last resort and as providers of funds for financing reversed some of the extreme distortions seen in what used to be considered the most liquid markets. 

The second focus of a liquidity shock or crisis is with the economics of the firm. Some will call this accounting liquidity. A slowdown in sales from sheltering in placing and business closings will mean a lack of firm cash flow liquidity to meet ongoing business obligations such as rent, payroll, and accounts payable. If cash is exhausted, the business and household cost is high without any relief. This is being solved with fiscal policy. The question is whether it will be fast or large enough to offset any economic gridlock. 

The third liquidity shock focuses on the core function of capital markets and banking. Tighter liquidity conditions mean the cost of borrowing will increase. A negative shock will also see an increased demand for margin and collateral as the value of existing collateral is called into question. Tighter banking feeds back on the economic or accounting liquidity shocks while the higher margin requirements will impact pricing liquidity. This shock is where the Fed will step in with lending programs and changes in bank regulation.

We may be through the worst effects of the pricing gridlock. The lending and leverage effects are being worked through albeit far from solved. However, the economic effects on households and businesses may have the longest lasting and greatest negative effects. Stressed business and households cannot be snapped back like a rubber band. This is also where the impact of policy is most uncertain.  

When discussing this liquidity crisis, break the discussion into these three areas of core stress.   

Tuesday, April 7, 2020

Uncertainty and the COVID-19 recession - It is all about the uncertainty

What will be the impact on US economic growth from the COVID-19 pandemic? This is not an easy problem since we have limited history to make any comparisons or projections; however, it is still important to try and provide some figures to guide policy and investment decisions. A new forecast has been generated by Scott Baker, Nick Bloom, Steve Davis and Stephen Terry in their just released paper "COVID-Induced Economic Uncertainty"The authors are known for their construction of uncertainty indices. We have been avid follower of these uncertainty indices and tools and think this is a fruitful direction for forecasting.

The novel approach is to use real time uncertainty indices and a disaster analysis model to generate their forecast estimates. The authors use stock market volatility, newspaper-based economic uncertainty, and subjective uncertainty from business surveys taken through March along with a model that has looked at past disasters to generate their VAR (vector autoregression) forecasts. They are looking at a decline of 11% GDP by 2020:4 with a 90% confidence level. 

Clearly, these numbers can change as we receive more information, but their focus is timely and emphasis is on what may be the most important current factor, uncertainty. They estimate that 60% of the decline will be uncertainty induced. Uncertainty causes fear, creates a demand for holding cash, and kills the animal spirits of optimism that often drive investment decisions. In an environment where we are breaking new ground every day, this may be as good a starting place for further discussion as we can currently find.