Tapering, The Return of Growth, and Oil's 7-Years High

IN THIS PUBLICATION:

• Don’t be afraid of a more hawkish Fed (for now).

• We might slowly be returning to the pre-2020 market setup.

• Oil nears 7-years high and is likely to sustain these levels for longer.

The Fed Last Week

The biggest change we‘ve seen since last month is Central Banks are now considering more inflation risks. This has come after:

• BoE flagged purchases could slow down as it now forecasts the fastest UK economic growth in 70 years (+7.25% in 2021, up from 5% only a couple of months ago).

• The ECB highlighted the high level of “exuberance” currently present in the market, which could be interpreted as the central bank becoming more cautious about the consequences of coordinated central bank easing.

• The Fed, at least optically, moved towards a more hawkish stance as it now ‘expects’ to hike rates in 2023 (vs. previously stating rate hikes will not come until 2024) on the back of higher economic growth and lower unemployment.

In J. Powell’s words, the Fed’s meeting last week should not be interpreted as the sudden start of tapering initiatives, but rather as “the talking about talking about tapering meetings”. But the market believed otherwise, and thus reacted pronouncedly last week.

• We saw an outperformance of Growth over Value. Yields on the short end, which tend to be driven by Central Banks policies rather than economic indicators, fell proportionately as well.

• Copper, the favorite proxy for economic activity and the reflation trade, lost significant ground.

• Gold followed suit, breaking the rally that was in place since March.

All in all, it’s hard to say this is surprising or unwarranted. Two rate hikes from historical low levels, paired with increasing risks of inflation and an unprecedented amount of liquidity in the market hardly seems to be the boogeyman that will crush the mighty Mr. Market. Two 0.25% rate hikes would still keep the Fed Funds rate below 1%, which is slightly below the level ex-Fed Chair Paul Volcker needed to break the hyperinflation of 70s and early 80s. Image markets today with 15%+ effective fed funds rate. (#stealingfromthefuture)

Paul Tudor Jones came out pre-Fed meeting on CNBC saying that if the Fed continued to highlight inflation threats as “transitory”, then that would have been a blessing to go “all-in” in inflation trades. Whilst that has not materialized, how much has really changed? We quote him (slightly edited for ease of reading):

• “The idea that inflation is transitory to me is one that just doesn’t work in the way I see the world. So, I look at $88 trillion of assets that are managed by asset managers and, of that, $670 billion are invested in commodity indices like Bloomberg Commodity Index, Goldman Sachs Commodity Index - so that’s about three quarters of 1%.”

• “If I rewind just to 2011 when inflation was peaking at 3%, (versus CPE currently at 4.9%), those same investors had 1.2% of their assets in Commodities which would imply today, if they just went back to the same level of allocation, another $400 billion of buying in commodity indices. The impact models that we run imply that GSER or BCOM would double or triple from here in that scenario.”

As it stands today, the Fed is buying 54% of 2021 US Treasury issuance, relative to 72% in 2013 (when we had the Taper Tantrum). This would imply the Fed needs to taper faster and in higher volumes in order for the market to feel the same withdrawal symptoms.

Lastly, even if the Fed were to taper faster and in higher volumes, there is not much “historical” downside to play for on the back of Tapering fears – both in mid-2013 and early 2014, the market crashed 6% on higher rates fear, so not the end of the world (and just a regular Tuesday morning for Crypto fanatics or SPAC enthusiasts… #timisbroke).

Tapering is not as worrisome as it once was, at least for now.

US Dominance Continues

On one side, the reflation trade, for conservative investors, continues to be the more rational approach to managing assets in the current market environment of high valuations, extreme stimulus and liquidity, and high levels of uncertainty. On the other, growth has been performing well and currently sits at an important technical level, which, if you believe in this sort of astrology, may set up its outperformance for the second half of the year. Consider this:

• The NASDAQ is trying to break out to new all-time highs, which is of particular importance as the Nasdaq tends to outperform the S&P500 in the second half of the year at a faster pace than in the first half. We’ve argued in a previous publication that there’s a real possibility that after all that happened in 2020, the end result may simply be the return back to the pre-pandemic status quo of US and US Tech outperformance.  The circle of life for finance nerds.

• This is being reflected in equity inflows, which, whilst they are currently record-breaking across the board, have been acutely pronounced in the US.

• Share buyback authorizations, a key theme of the pre-2020 equity markets and a thematic that is very prevalent in the US, continue to come in strong with YTD authorizations 13% higher than the highest year on record (2018) and 1.4x last year’s levels (to be expected though given that cash was at a premium and the Fed was freezing bank share repurchase programs).

• The US Dollar has moved higher in recent months (if you remember, higher US Dollar works against the reflation trade), and is near an important technical level which it tried to break out of in early March.

• This technical level could lead to a small-short term correction, or else break out higher, which would fuel the Nasdaq and US market dominance further… at the expense of the reflation trade (we’ve frequently said that the current reflation trade was more of a lower US Dollar driven narrative rather than synchronized global economic growth one, and as such, the future of that trade will depend on what the greenback does). In any case, the direction of the US Dollar matters even more than usual right now.

Put simply, the market is slowly moving against the reflation trade and towards the set up that was dominant pre-2020. Whilst this is still early days, both the NASDAQ and the US Dollar’s current levels could become an even more important leading indicator for what lies ahead.

Understand The Crowd You’re Talking To

With the Taper Tantrum looking less of a boogeyman for now, and the continued performance of US assets (mainly Tech), the key question to understand is what happens to the consensus reflation trade?

Investors went into the FOMC meeting very long the reflation trade, and subsequently felt the pain post-meeting. But what does this mean going forward? Well, as always, it depends on who you’re asking and what they care about.

• Paul Tudor Jones, like many others, seems to still like the Reflation trade. That might sound a bit paradoxical because he’s a trader by craft, meaning that he’s more short-term focused. He likes to be 5% in Gold, 5% in Bitcoin, 5% in Cash, and 5% in Commodities. For the remaining 80%, he doesn’t really know… and as such, we might ask Tim and revert back (he’s probably 20x levered on Crude and Mexican Tequila right now [Tim’s note: is there any other type of tequila Diego?]).

• So, if he’s a trader, why isn’t he chasing the breakout and momentum trades that seem to be available right now in the NASDAQ and USD?

• Because his job is to preserve wealth rather than speculate. He considers himself one of the most conservative managers out there, meaning that his focus is on protecting his assets from risks like higher inflation rather than trying to find the next Amazon.

• This doesn’t make him right or wrong, but rather consistent with his investment philosophy.

• On the other side, you have an investor base that is eager to focus on finding the next Amazon (which, even if inflation picks up, promises more than offsetting levels of returns).

• These are the people that chase growth trades and get compensated if higher levels of liquidity are available to finance ideas that will only bring cash flows years down the road. This kind of investor, whilst also neither right or wrong, is willfully operating with higher levels of speculation and, truth be told, is the kind of investor that has been right for the past decade in terms of returns. [Tim’s note: thank you Diego]

Higher rates affect different investment philosophies in different ways, and when reading the opinions on the impact of tapering on financial assets in financial media, it’s always important to frame the investment philosophy of the interviewee ahead of making any sort of conclusions. We’ve learned this the hard way. [Tim’s note: speak for yourself Diego]

Oil’s Closing Up to 7 Year High

Of all the trades Tim has been right on (can be counted on one hand), long oil is one of them.

Back in the middle of the Pandemic, he wandered around an empty city of Lisbon, thinking about ways he could take delivery of barrels in the city of Belém (where Portuguese sailors departed from in the XV century when India was yet to be discovered). He quickly understood that as a speculator, the best way he could express this view was instead by going irresponsibly long XOM (there is only a limited amount of barrels that can be stored in Selina hostels). As painful it is to say, he was right. [Tim’s note: this story is not a lie, though it leaves out the fact that I then got greedy, sold it all, put it on MARA and RIOT, and well, go look at their charts…]

Crude Oil and the XOP are up 90% in the last year. In comparison, Gold is flat and Copper (the reflation sweetheart and one of the most important commodities for the Green Transition) is “only” up 60%.

Goehring & Rozencwajg, who were spot on since the beginning, recently commented:

• “Global oil markets are firmly in deficit, as evidenced by rising prices, falling inventories, and growing backwardation. After having peaked in June 2020 at nearly 400 mm bbl above average, OECD inventories have drawn by 250 mm bbl relative to seasonal averages, suggesting the market has been 1.2 m b/d in deficit — the highest reading on record.

• We expect this deficit will grow as we progress through the year. Inventory data in the US shows continued draws relative to seasonal averages in March and April, albeit at a slower rate.”

As they’ve explained to us in the past, all non-OPEC+ supply growth of the last decade came from the US, which is currently facing a well depletion issue (in basic terms, companies have already drilled their “best located wells”, where productivity is higher, and are now forced to drill less productive wells if they want to grow supply). See chart #4 here.

This likely means the US will not be as able as in the past to grow production at will, meaning the future of oil prices rests in the hands of what OPEC decides to do. That said, it does seem that, for the first time in more than seven years, we might have a favorable backdrop for seeing oil prices at a higher level for a sustained period of time. The one caveat here is that OPEC is sitting on an all-time high spare capacity, as we reported on here.

As Goehring & Rozencwajg put it: “We have entered a new era in global oil markets. The only source of non-OPEC+ growth over the past decade is now suffering signs of sustained depletion. Most analysts believe the shales will exhibit strong growth again when oil prices recover; however, our research tells us that growth from the shales will fall far below expectations in the first half of this decade”.