OIL no Longer the Evergreen Asset Class: Has the Oil Demand Peaked.

OIL no Longer the Evergreen Asset Class: Has the Oil Demand Peaked.

Timing is everything when it comes to investing in commodities. In 2014, oil was considered one of the safest bets. The reasoning among big financial investors was straightforward. Regulation and technology might crimp demand in the industrialized west, but as more of the developing world’s poor moved into the middle class, oil demand and prices would remain strong. Skip forward to 2016, and many analysts, including those in strategic planning departments of big oil groups, are starting to warm to the idea of peak oil demand globally, not just in the OECD.

In part the exercise has been driven by shareholders and activists who say the companies are ignoring the risks to their business from a global climate accord. A number of organisations, notably the International Energy Agency but including oil companies such as Statoil, Shell, BP, Total and Conoco Phillips, are modelling outcomes based on a breakthrough in battery technology or that global temperatures rise by no more than 2 degrees Celsius.

These scenarios include rising solar energy and natural gas use, cheaper car batteries, urbanization supported by millennial ride sharing and public transport, and advanced, digital energy-saving technologies. Many of the studies project a fall in oil demand to 75m barrels per day by 2040, from about 95m b/d today.

After testing for oil demand sensitivities and found that a combination of factors; slower than expected growth in the developing world, improved logistics, advances in vehicle efficiency could, perhaps with a push from policy, see demand for oil peak, at least for a decade or two.

The implications are bigger than they might seem given the number of ifs that surround the idea that oil demand could peak. For the past three decades, investors have assumed that oil under the ground today will be more valuable in the future. That has led them to seek companies best positioned to deliver growth. But if the rise in oil demand is uncertain, all bets might be off. That means investors do not simply want exposure to crude. They will need to select a management team that is nimble, no matter whether demand rises, falls or remains flat.

Moreover, in a more competitive world where producers might have fewer opportunities to sell its product, all investable oil assets will not be equal. Investors will have to know what the production cost basis is for a company’s reserves or how well positioned their refinery network is to beat global competitors. Location of assets will matter. Owning a refining and marketing network in California, or Germany, where demand will almost certainly fall off, might be less attractive than in India or Malaysia.

The use of automation and other emerging technologies to drive returns will matter. Technology advancements had lowered the company’s production costs excluding taxes to $2.25 a barrel for horizontal, low enough to compete with Saudi Arabia. By contrast, operating costs in Canada’s oil sands are estimated at $37 a barrel.

For 30 years, the industry has operated under the principle that it will have difficulty meeting demand. Against that backdrop, adding reserves to the balance sheet was an end unto itself, sometimes more important to management than if those reserves could be profitably produced.

The thesis was that oil would become increasingly scarce as easy to reach reserves were depleted; the value of booked, warehoused reserves would appreciate with global prices and a day would come when even ridiculously expensive assets would be profitable to produce.

But if oil demand declines before those expensive reserves are needed, mindlessly booking reserves is not a strategy Wall Street will want to reward. Investors might ask more critically what a company’s revenues outlook will be this quarter or next, like most other ventures. Understanding which companies can pivot best to new realities will be key to smart investing in oil.

All investable oil assets will not be equal in a more competitive world.

-     -   Farzan Ghadially

Gold: The Good Money

Gold: The Good Money

Gold prices have rallied more than 30 per cent since the lift off in US interest rates in December. A sharp reversal in pricing, sentiment and positioning driven by myriad factors has left gold bears and bulls as polarized as ever.

The bearish camp, with analysts such as those at Goldman Sachs, tends to have a constructive view on the US dollar and the ability to raise interest rates and normalize global monetary policy, and generally a benign view on the global economy and inflationary risks.

In the bullish camp, the view tends to be more pessimistic on the global economy and the unintended consequences of monetary policy without limits. It sees the recent price action as the beginning of a multiyear bull run in gold.

There are three main factors that support the rise of Gold prices, resulting in gold being the good money in the years to come.

The first is the limits of monetary policy. In response to the Lehman crisis and to combat the threat of deflation, central banks have deployed a wide range of unconventional monetary policies. Quantitative easing and negative interest rates have been game changers, distorting the valuation of government bonds, breaking the theoretical ceiling in prices, squeezing shorts and underweight positions, and feeding what, is one of the largest financial bubbles in history.

At the epicenter of the problem are the central banks. Investors and savers around the world, faced with extraordinarily low and even negative yields in cash and fixed income, have been incentivised if not forced to lengthen the duration in their portfolios, increasing the risk of capital losses, liquidity and volatility beyond what they might intend or be able to tolerate.

Second, examine the edges of credit markets. The bubble in government bonds and duration has driven risk taking across equity and credit markets, and lending to weaker and weaker credits, often ignoring or underplaying the risk of capital losses, liquidity and volatility. It’s a bull market that feeds on itself and benefits the weakest players most, such as emerging markets or high yield.

In a world with limited investment opportunities, excessive risk taking can lead to speculation and, of course, bubbles. The damage is done but can get worse, especially if countries such as China respond to future crises with more aggressive credit expansions, as it did this year.

The current path of monetary and credit expansion is unsustainable and will eventually burst, leaving investors struggling for the return of their capital, instead of return on their capital an extremely bullish scenario for gold and other real assets.

Third, the limits of fiat currencies are being tested. Unlike in the global financial crisis of 2008, this time there won’t be any monetary bullets left. Interest rates are already at record lows, asset purchases suffer from the law of diminishing returns, and competitive currency devaluations only increase underlying problems and global imbalances.

Over the past few years we have witnessed the first stage where by bad money displaces good money, and we are at the early stages of the second and final phase, whereby good money displaces bad money.

Gold and the dollar are best placed to play the role of good money, which could result in a substantial appreciation against the bad money currencies. But the inability or unwillingness of the US to normalize its monetary policy leaves the door wide open for gold to retake its reserve currency status and put an end to the monetary super cycle that started in 1971 with the end of Bretton Woods. It is a period in which the outstanding volume of paper money has grown disproportionately to the amount of gold that once backed it.

Time will tell if central banks and governments will be able to engineer a smooth solution to the challenges ahead, or if the remedy will be worse than the disease.

Monetary policy without limits will lead to a very wild and bumpy ride and a larger crisis than the one we have been trying to resolve: which could result in a perfect come back for Gold as an asset class that would shine in times to come.

_ Farzan Ghadially

Liquidity Liquidity Every Where Will There Be a Recovery!!

Liquidity Liquidity Every Where Will There Be a Recovery!!

With the gush of liquidity from most Central banks around the world, the markets are moving to new highs without a real recovery in the earnings, will this ever greening of liquidity help in actual revive or does it just postpone the eventual danger of the collapse of markets world over.  

Policymakers have chosen to ignore the central issue of debt as they resuscitate activity. Since 2008, total public and private debt in major economies has increased by more than $60tn to more than $200tn about 300 per cent of global gross domestic product, an increase of more than 20 percentage points.

Over the past eight years, total debt growth has slowed but remains well above the corresponding rate of economic growth. Higher public borrowing to support demand and the financial system has offset modest debt reductions by businesses and households.

If the average interest rate is 2 per cent, then a 300 per cent debt to GDP ratio means that the economy needs to grow at a nominal rate of 6 per cent to cover interest.

Financial markets are now haunted by rising debt levels which constrain demand, as heavily indebted borrowers and nations are limited in their ability to increase spending. Debt service payments transfer income to investors with a lower marginal propensity to consume. Low interest rates are required to prevent defaults, reducing the income of savers, forcing additional savings to meet future needs and affecting the solvency of pension funds and insurance companies.

Policy normalization is difficult because higher interest rates would create problems for over-extended borrowers and inflict losses on bond holders. Debt also decreases flexibility and resilience, making economies vulnerable to shocks.

Attempts to increase growth and inflation to manage borrowing levels have had limited success. The recovery has been muted.

Sluggish demand, slowing global trade, capital flows and demographics, plus lower productivity gains and political uncertainty are all affecting activity. Meager commodity prices, especially energy, and overcapacity in many industries have kept inflation low.

In the absence of growth and inflation, the only real alternative is debt forgiveness or default. Savings designed to finance future needs, such as retirement, are lost.

Additional claims on the state to cover the shortfall or reduced future expenditure affect economic activity. Losses to savers trigger a sharp contraction of economic activity. Significant write downs create crises for banks and pension funds. Governments need to inject capital into banks to maintain the payment and financial system’s integrity.

Unable to grow, inflate, default or restructure their way out of debt, policymakers are trying to reduce borrowings by stealth. Official rates are below the true inflation rate so over-indebted borrowers to maintain sustainability high levels of debt. In Europe and Japan, disinflation requires implementation of negative interest rate policy, which entails an explicit reduction in the nominal face value of debt.

Debt monetisation and artificially suppressed or negative interest rates are a de -facto tax on holders of money and sovereign debt. It redistributes wealth over time from savers to borrowers and to the issuer of the currency, feeding social and political discontent as the Great Depression highlights.

The global economy might have become be trapped in a quantitative easing forever cycle. A weak economy forces policymakers to implement expansionary fiscal measures and QE.

If the economy responds, then the side-effects of QE encourage a withdrawal of the stimulus. Higher interest rates slow the economy and trigger financial crises, setting off a new round of the cycle.

If the economy does not respond or external shocks occur, then there is pressure for additional stimuli, as policymakers seek to maintain control.

Economist have been very pessimistic and feel that there is no means of avoiding the final collapse of a boom brought about by credit expansion. The point is   only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. Negative rates are a de facto tax on holders of money and sovereign debt.

-        --Farzan Ghadially

Emerging Markets to face Turbulent and Cloudy Weather in the Near Term

Emerging Markets to face Turbulent and Cloudy Weather in the Near Term  

With the GST being passed after much anticipation, the equity markets failed to impress in the very near term and the expected jump of a couple of percent in the markets did not really happen. In the near term the Emerging markets equities’ long bear market could be over. As of this week, MSCI’s emerging markets index has outperformed its developed markets index over the past 12 months — the first time this has been true for several years.

But that recovery owes much to lackluster developed world growth and recent weakness of the US dollar. After a protracted bear market, a “dead cat bounce” is to be expected. In absolute terms, emerging markets have not recovered at all. As of Tuesday, the EM index was down 2.6 per cent over the previous 12 months. It had not repaid investors. So can EM’s latest revival be trusted?

A look at the sectors and geographies that have prospered suggests caution. The biggest contributors to the MSCI EM over the past year have been Korea (barely an emerging market at all), and Brazil, an intensely speculative destination given its economic problems and political uncertainties. The strongest performer, Peru, has rallied 23 per cent but relies almost entirely on industrial metals.

The two biggest emerging economies, China (down 12.5 per cent) and India (down 4.1 per cent) have registered declines. With India facing resumed uncertainty after the departure of the much respected Raghuram Rajan at the central bank, and China witnessing a fresh turn towards authoritarianism, there are compelling reasons for caution over both. Yes, long-term prospects for the two, as they steadily make up ground with the rest of the world, are strong; their nearer term prospects are cloudier.

At a sectoral level, emerging markets over the past year have relied on materials and information technology, the only sectors to have risen. A resumed decline in metals prices (or oil) would hurt.

Valuations are another concern. The big reason to hunt emerging market assets is yield. In fixed income, there is extra yield to be had. In equities, the rally has gobbled up almost all the opportunity. According to MSCI, emerging market stocks yield 2.65 per cent, versus 2.56 for developed markets. The highest yields come with big political and governance risks, from Russia (4.65 per cent) and Brazil (3.49 per cent). With the hunt for yield looking extreme — witness the flood of US corporate issuance vulnerability to a short-term reversal, especially if the Federal Reserve raises rates next month, looks serious.

Judged by book value multiples, the emerging world is cheap (at a 1.5 multiple, compared with 2.17 for the developed world), but the best value can only be had where there is most risk. Greek equities sell for a 56 per cent discount to book value. Of countries exciting positive commentary for their reforms in recent years, Indonesia trades at 3.09 times book, and India at 3.17 times. At least in the short term, compelling cheapness is not there.

Another reason for short-term caution comes from flows. Money has poured back in to emerging markets this year, largely from European equities. The $34bn that arrived in the past six months cancelled out previous outflows. Investors are no longer significantly underweight.

This is important, because for many investors (US-based), their essential decision will be how to balance their non-US equities between EM and Europe. A good case can be made for Europe, that Europe would be will be more appealing in months to come. More stimulus from the Bank of England and European Central Bank would help and in terms of forward earnings multiples, cuts in European earnings forecasts and the rally in EM have left Germany’s Dax index trading at a premium of only 1 per cent to EM. It tends over history to trade at a premium of 8 per cent.

For the long term, EM looks as appealing as ever, due to long-term growth prospects and valuation. Using the cyclically adjusted earnings multiples, EM trades at 11 times average 10-year earnings, near its low and slightly cheaper than developed markets outside the US (13). The US, at 26, is far more expensive.

Sentiment towards emerging markets tends to move in long waves, so signs that mood is shifting are positive for the long run. But in the short term, EM is vulnerable to a rise in bond yields, or to resumed risk-aversion. This is not the time to make a big top-down asset allocation switch towards emerging markets.

_ Farzan Ghadially

Is this the calm before the storm??

Is this the calm before the storm??

With artificial calm being created in the world markets, is it the calm before the storm and are the markets looking stretched and looking over priced with the artificial injection of liquidity world over or is this state here to stay for a longer period??

With the Sensex at ~28,000 and most of the so called markets pundits being extremely optimistic about the Indian markets and the political landscape looking slightly positive that market reforms like GST would be passed very soon, is the time to go all out on equities or have a cautious stance on the markets is the big questions. With the Indian markets highly dependent on the liquidity flows from foreign investors, it is imperative to look at the overall global picture….

While global economic and political developments point to the possibility of “jump conditions” once deemed improbable, financial markets have treated their influence as temporary and reversible. This divergence is understandable in the short run. Longer-term, however, it sets up complex dynamics that call for investor adaptations.

In the past few weeks, the UK voting to leave the EU and the setting of record high prices by the US equity and bond markets simultaneously added to an unusual period for a global system with more than 30 per cent of its global government debt trading at negative nominal yields.

The sense of fluidity intensifies when you add to the mix fragile Italian banks, an attempted coup in Turkey, and tragic illustrations of vulnerability to lone wolf attacks.

These issues share a potential for fueling so-called jump conditions in which there is a leap to a different set of circumstances, rather than a smooth and incremental evolution. They could change longstanding economic and financial relationships, affect the way economic agents interact with each other, fuel political anomalies and, in the case of unusual asset class correlations and valuations, undermine some of the institutions and basic tenets of the capitalist system.

This phenomenon is not limited to the past and present. Also, there are potential jump conditions on the horizon which are as follows;

The October referendum in Italy could complicate European politics already challenged by the legacy of the financial crisis, migration questions and Brexit.

The US faces its own unusual election in November. China’s ongoing political changes coincide with its leaders having to manage a middle income development transition rendered more difficult by international economic headwinds and domestic financial bubbles.

Meanwhile, unease about policy effectiveness grows in a world that has been over-reliant on central banks and that will probably see three of these systemically important institutions (the Bank of Japan, the European Central Bank and the People’s Bank of China) pulled even-deeper into the uncharted waters of monetary policy experimentation.

But measures of market sentiment have been remarkably calm. Just look at the Vix, the so-called “fear index” that captures the extent to which investors are unsettled by uncertainties. Spikes have been infrequent and quickly reversed. Its most distinguishing feature is that of overall stability at subdued levels.

There are good reasons for this. Liquidity injections, both actual and expected remain ample on account of central bank stimulus and corporate cash being recycled back into markets via share buybacks, mergers and acquisitions. Investors have been conditioned by years in which “buy on dips” approaches have repeatedly proven profitable, especially in markets recently achieving new highs.

Few investors have rushed to reflect the reality of elevated prices and unstable asset class correlations back into their strategic asset allocation, particularly given unchanged investment objectives.

Lacking attractive alternatives, and with limits on how much cash traditional investment managers can hold, equities continue to attract a disproportionately large allocation.

It is understandable for markets to trade on the current reality of cash flow and put aside the possible consequences of the gap between investor behavior and a growing list of unusual economic and political uncertainties. In the process, however, a cocktail is brewing that risks future financial volatility and jump conditions in various market segments.

Investors should look at more of a barbelled approach that combines higher cash allocations with greater exposure to alternatives; become more tactical and using scenario analyses, prepare stakeholders for unsettling volatility down the road.

The biggest mistake for investors is to believe that this period of artificial market calm is destined, in itself, to lift the fundamentals that ultimately determine asset value. The opposite is, unfortunately, more likely.

_ Farzan Ghadially.