The ECB led by Mario Draghi put all its chips on the table and went all in with its aggressive policy moves last Thursday. Whether that is enough remains to be seen, as QE has not done the trick up until now and the Eurozone stays stuck in the mud with inflation still nonexistent. But maybe the ECB has finally found the right balance to stimulate growth and increase the rate of inflation while not destabilizing the currency markets.
Was there an agreement at the G-20 meeting last week not to enter into a competitive devaluation game? If so, as many believe, that explains why the Euro and the stock markets, which plunged initially on the news fully recovered fully on Friday. This really is a chess game of global proportion, which frankly, we relish and excel in.
And to top it off, it appears that Iran has come to the table to join in on a production pack if conditions are reached with the major oil producers. More to follow!
Our funds continue to significantly outperform all averages with strong absolute gains. It certainly helped that we covered our energy shorts four weeks ago, as reported here, and went long the financially strong and low cost industrial commodity producers. We hit the ball out of the park on both counts.
Next up the BOJ on Tuesday and then the Fed on Wednesday followed by a potential deal in the energy patch to freeze production. How intriguing! The pundits may have it all wrong once again.
Let's look at the key data points last week and what we expect this week with an eye on how and if our core beliefs, capital allocation, risk controls and investment selections may have to be altered. Change is in the air!
1. Mario Draghi and the actions of the ECB took center stage last week as it had a major impact on the global markets, which we will explain soon. Let's first list the ECB moves: the main interest rate was cut to 0 from 0.05%; the deposit rate was cut to -0.4% from -0.3%; the marginal lending rate was cut to 0.25% from 0.3%; QE purchases now including corporate bonds were increased to 80 billion euros per month from 60 billion euros and a long term bank lending program was initiated paying banks to lend. Germany opposed the ECB moves.
Banks will essentially be provided with long-term cash free of charge and will be paid by the central banks 40 basis points if they lend out money. Not surprisingly, the ECB lowered its Eurozone growth forecast to 1.4% this year and 1.7% in 2017 from 1.7% and 1.9% respectively and also lowered its inflation forecast to only 0.1% in 2016, 1.3% in 2017 and 1.6% in 2017 which all remain below the 2.0% target of the ECB. Economic data out of Europe reported last week remained weak as anticipated.
One of the key impacts of all of the above moves is that multinationals will rush to issue debt in Europe at ridiculously low rates replacing higher cost debt reducing interest costs, enhancing earnings, lengthening debt terms, improving liquidity and cash flow.
Draghi concluded that rates would not go any lower which ended up supporting the Euro.
2. The blue print for a global energy deal is on the table and is the very one that we predicted a few weeks ago when we announced that we were covering our 3 year-old energy short position. It was a great investment call for us!
Iran's bargaining point is that they are willing to freeze production at around 4 million barrels per day, which is up 1 million barrels per day (b/d) since sanctions were lifted, but still below former levels. Other producers state that they want to maintain their production at January rates which would mean that global supply will exceed demand by 1.5 million b/d as non-OPEC supply is expected to decline by 750,000 b/d. If demand continues to grow from a base of near 100 million b/d, the market could be in balance by the fall of this year and in a deficit sometime in 2017 if producers stick to their agreement.
So, why have oil prices shot up so much in recent weeks if the market is still in an oversupply position? The easiest answer is that the price decline overshot on the downside as everyone in the world is short energy, including producers, and it was not a two-way market. Goldman and others were calling for $20-dollar oil and placed their bets accordingly. Should oil be $40 dollars per barrel today is a difficult question to answer but I am reasonably confident that oil prices have bottomed therefore speculators/traders need to control their risk, reduce their exposure and cover at least some of their shorts.
I found it noteworthy that Saudi Arabia, the most important and influential player in OPEC, is seeking an $8 billion loan to fund its widening fiscal deficit, which only grows larger unless oil prices stabilize and recover.
Higher oil and industrial commodity prices, which have rallied significantly too, as it was also an overcrowded trade, have shifted the investor mindset regarding deflation. This is an important comment and impacts asset allocation as well as potentially company fundamentals, and therefore, investment selections both on the long and short sides of the markets.
3. The upcoming Fed meeting is the key event facing us this week and will take center stage for sure. If you believe, as I do, that there was a quasi agreement at the G-20 meeting not to enter in competitive devaluations, then you would also agree that the Fed will hold off raising rates at this meeting knowing that the ECB and BOJ would be taking further monetary actions to stimulate their economies and boost inflationary expectations.
The view that low inflation may no longer be just transitory is clearly the biggest change in mindset of most fed governors. Vice Fed Chairman Stanley Fischer is on the other side of the argument believing that low unemployment will lead to higher inflation. Clearly he has not factored in sufficiently global competitive forces and new uses of technology that are impacting retailing, hotels, taxis, car rentals, industry etc., etc. that we have discussed in the past like Amazon, Uber, and Airbnb. Have you seen the new GE ads? It is all about technology changing its businesses and becoming more competitive globally.
Economic data points reported last week were mixed: U.S. household net worth rose to a record $86.8 trillion; import prices fell by 0.3% in February and down 2.5% from a year ago even excluding food and energy; the budget deficit was $192.6 billion in February, a seven-year low; wholesale sales fell 1.3% in January while inventories rose 0.3% increasing the inventory/sales ratio to 1.35; small business optimism fell to 92.9 in January and consumer credit rose by $10.54 billion in January.
The U.S economy remains on track to achieve 2-2.5% GNP growth in 2016 with minimal inflationary pressures.
4. The BOJ is facing a hard decision this coming week as economic activity in Japan has remained weak including private consumption, which was to be boosted by lower energy prices. Japan's economy declined by an annualized rate of 1.1% in the fourth quarter and economic indicators for the first quarter remains weak. Monetary authorities were caught off guard by the reaction of investors to negative rates as risk assets were reduced and the yen surprisingly increased further exasperating the BOJ attempts to simulate growth.
We expect the BOJ to make some adjustments to its monetary policies to be less punitive to short term funds and to be more beneficial to financial institutions making loans to more productive assets much like the ECB. I certainly hope that the government postpones its next retail tax increase and takes actions to further stimulate wages and investments.
5. China remains the one country acknowledging its problems and introducing programs to improve the situation for years to come. The economy continued to slow in the two months of the year: industrial production grew by only 5.4%; retail sales grew by 10.2%, both down from December's rate of gain; fixed investment grew by a strong 10.2%.; exports fell by 25.4% in February while imports declined by 13.8% resulting in a trade surplus of $32.6 billion down from $63.3 billion in January; and foreign reserves declined by only $28.6 billion in February ending at $3.2 trillion.
China plans changes in its income tax policy to stimulate consumption and letting banks sell off some of its bad debts to investors. Other regulatory and financial policy changes are clearly under consideration. By the way, the yuan rose to a new high for the year last week baffling speculators. Don't bet against China!
So where does all of this leave us? It is clear that a change in the mindset of investors has been occurring over the last four weeks including expectations for economic growth and better pricing as energy and industrial commodity prices have stabilized at higher levels. It is now our belief that both energy and industrial commodity prices overshot on the downside and speculators/traders are covering some of their positions to reduce risk and leverage. Have we reached equilibrium yet? I am not sure but I do know that we have past bottom and prices will be moving up over the next eighteen months as long as the global economies expand.
The U.S stock market is still undervalued based on fundamentals but I am remain concerned by the impact of the presidential campaign on market psychology as the rhetoric from both sides is extreme and bothersome. The market cannot get out of its way until there is more clarity about the views of the candidates on economic and foreign policy. We need to be convinced that Washington has gotten the message from the electorate and that positive change will finally occur for financial, regulatory and tax policies.
As long as I feel that the stock market is undervalued, I will invest in companies that are positively making changes to enhance their global competitive position, increase volumes, margins and profits and continue to generate excess cash flows, as they will be revalued over time. My shorts are the flip side of my longs and have entered a secular decline. We remain 94% net long and maintain substantial excess liquidity at all times.
So remember to review carefully all the facts, take a long pause to reflect, look for a shift in mindsets, first look at capital allocation, then control risk and finally do in-depth research on each idea as opportunities are everywhere as is change...
William A. Ehrman is managing partner at Paix et Prosperite LLC.