First, let’s review 2015 to see what could occur in 2016. What was most noteworthy was the continuation of investor focus on central bank interventions vs. fundamentals across all asset classes. That focus has continued since the 2008 crisis and if anything has gotten worse.
The overall theme as a result has been: long high-risk, high-beta such as technology/biotech and short commodities, which accelerated beginning last year when the Fed signaled its desire to raise rates and refrain from more QE, as it allowed the EU and Japan to take lead on QE.
The so-called China “crisis” last summer ended like every other crisis – largely seen as a day trading event that quickly became ignored as focus shifted back to what central bank polices will be. Chinese authorities basically strong armed markets from collapsing by imposing trading restrictions.
Buy the dip theme continued to be the favored course despite deteriorating macroeconomics as U.S. retail spending, manufacturing, trade and capital expenditures all markedly slowed, as did the overall U.S. GDP and global GDP for that matter. Related: Energy Markets On Edge As OPEC Meeting Nears
Markets started the year expecting 3 percent GDP in the 2nd half of 2015 but are now likely to end below 2 percent, yet financial markets are near highs mostly driven by large cap names (FANG – Facebook, Amazon, Netflix, Google—45X P/E combined!).
Credit markets largely deteriorated as well, especially in high-yield, which declined some 20 percent on an average. Access to credit became increasingly hard to come by for the energy sector as banks tightened their policies. The energy sector saw a 50 percent decline in debt issuance throughout Q3.
We also sensed that private equity also got tighter due to the ongoing fiasco at SunEdison, which witnessed a 90 percent plunge in its share price. Investors finally realized that their debt/equity at 600 percent was unsustainable and questioned their ability to sell projects off to private equity to finance its business.
Surprisingly enough, this event was largely ignored in the clean energy-biased media while energy default risk was all the rage. In energy we witnessed what looks like the start of an inventory and overall production decline, although the contraction has stalled a bit due to some seasonal factors.
Demand remained at five-year highs despite focus on absolute inventory levels. OPEC added to the existing supply pressure by adding over 1 million barrels per day (mb/d) since mid-2014, and the pending return of Iran to global oil markets following the nuclear deal also raises supply questions.
All of which translated to NYMEX futures net positions of front month remaining net-short and bearish as ever. Oil prices as a result continued to decline but hold above $40, eclipsing the longest period (even as compared to the 1986 crisis) on length of time for price recovery. Related: Shale Gas Revolution Is Not Done Yet
The main driver on the price pressure comes from currency markets, as the dollar was under pressure in the first half of 2015, but recently rallied because of more QE from the EU and an expected rate hike from the Fed. The oil price plunge and the USD have tracked pretty closely (inversely) since June 2014.
Recent terrorism events and geopolitical conflicts being largely ignored as markets rallied further on expectations of more QE in the Euro zone. All of this translated into a third quarter of 2015 where earnings slowed and revenue growth slowed even more. Some of the air in the technology/biotechnology bubbles was let out in part tied to slowing EPS and the attention brought to drug price increases and the VRX scandal.
At this moment, the dollar appears to be poised to move higher despite weakening U.S. economic performance, not because it should, but because the Fed desires it and will continue to play the rate hike card threat. We don’t foresee a change in the macro trade of long beta and short commodities with that in mind. Goldman Sachs’ chief equity strategist agreed in a recent CNBC appearance, despite valuations being in the 96 percent valuation range historically.
So take more risk right? The recent inclusion of the Yuan in the IMF basket of currencies in 2016 should incrementally add to dollar selling. However, how many times have we seen fundamentals ignored and asset prices move in the opposite direction because of central bank policy? A lot! So don’t bet on it.
Investors who still pay attention to fundamentals are largely sitting at the sidelines as reflected in lower market volume. Incremental volumes are from money center banks, algos and short sellers, and as a result we have a market driven by central bank interventions with asset prices becoming more and more distorted.
One relationship I repeatedly cite in measuring this distortion is the relationship between NASDAQ and oil prices, which have NEVER diverged before by this much in the stock market’s history. Related: Undeterred By Global Glut, U.S. Pushes Ahead On LNG Exports
If this doesn’t tell you what’s afoot I don’t know what does. I maintain it’s not a coincidence that this distortion is occurring and it’s born out of central bank policies vs fundamentals. My view is that the Fed is intentionally keeping the dollar strong (for a host of reasons) in part to depress commodities in lieu of more conventional QE.
And it’s fairly clear the Fed will raise rates despite the fundamentals dictating otherwise to reinforce that view of a strong dollar policy, even though there is pressure on corporate earnings.
In sum, the Fed has shifted from propping up Wall Street the last 7 years to propping up Main Street. QE has largely increased income disparity as the 1 percent have seen their wealth increase via asset price appreciation while Main Street suffered through inflation, decreasing wages, lower discretionary income and largely lower paying jobs in the service sector. Going into an election year do you think this shift is some coincidence?
2016 will likely bring more back door means to prop up flailing U.S. economy through higher fiscal spending, student loan forbearance or some gimmick to reduce bank reserve requirements, all with an eye on maintaining the dollar status quo.
Essentially what is going on is an attempt by the Fed to have their cake and eat it too by declaring victory, raising rates 0.25 percent, and maintaining all the benefits associated with lower commodity prices for Main Street as the U.S. dollar remains strong.
I don’t foresee anything other than a complete reversal in Fed policy or an OPEC cut to derail these trends.
Despite massaged economic statistics (overstating growth while under stating inflation) in 2016, U.S. GDP growth will likely remain slow. That will likely keep commodity prices depressed through the election cycle. In energy, I expect the U.S. supply/demand imbalance to improve dramatically. Every investor knows, whether they want to admit it or not, $40 Oil and $2.20 won’t produce free cash flow for E&P companies, especially when hedges will roll off in 2016.
As a side note: Chesapeake Energy recently admitted that in 2012 54 percent of projects weren’t cash flow positive, so clearly this cannot be sustained. If WTI remains under $50 U.S. oil production will decline by between 5 and 10 percent as E&P companies see the effects of depletion, hedges rolling off, debt funding drying up, and highly profitable projects become increasingly scarce.
By spring 2016 I fully expect a wave of defaults leading to a period of consolidation by oil majors and private equity. I don’t believe that this will lead to a Lehman like credit crisis when defaults begin. But it will constrain production, leading to a draw down in U.S. inventories and add to slower growth as it did in 2015. Whether that gets realized is another matter as the EIA/IEA continues to underestimate demand and over-estimate supply while OPEC continues to pump above its quotas.
Until pro-growth, low taxation and less regulation policy changes are enacted, I don’t foresee any changes to central bank policy nor the unsustainable market divergences and asset price distortions.
Expect more media propaganda on how great the economy is while the reality is another story. Early signs are that retail sales this holiday season are poor. Nobody can predict when reality will set in and equity markets revert back to pre QE levels in 2008/09. The longer this charade continues, the lower equity markets will eventually go, and in the short-term so will commodities. Then the super cycle in commodities will begin anew. Much this will hinge on next fall’s election cycle.
By Leonard Brecken for Oilprice.com
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