Apr 10, 2020
McCreath: Here's why my funds are shorting energy and tilting to U.S. stocks
March 2020 was an awful month for humankind, financial markets and our funds. North American equity indices saw total return losses of 12.35 per cent for the S&P 500 and 17.38 per cent for the S&P/TSX Composite Index. The waterfall declines were fuelled by the excess leverage in corporate credit and shadow banking, largely in the U.S., followed by a more general selling of financial assets. While the rapidity of the declines had the years 2008 and 1929 on the lips of some investors, unlike those bears, this attack was triggered by an exogenous event. Global equities lost US$7.88 trillion of their value during the month of March, and US$14.88 trillion since their high on Feb. 19.
Thankfully, it’s early in the year — plus, the ‘sell all mentality’ that levelled equity assets has turned the growth style of investing into the new value. Our hedge funds at Forge First have used this opportunity to shift the majority of our net long common equity exposure into U.S. stocks, focusing on the likes of consumer-oriented compound growers such as The Home Depot Inc., MasterCard Inc., Nike Inc., Best Buy Co. Inc., and Morgan Stanley. We’ve also added to long held positions Microsoft Corp. and Visa Inc., while initiating a position in special situation: Berkshire Hathaway Inc. We ascribe that term to Berkshire given its estimated US$130 billion of available cash as the company is much more likely to find accretive acquisitions as America has gone on sale. Of course, America being on sale today assumes the outbreak of COVID-19 peaks in April and thus enables economic activity to resume in May.
This past Tuesday, when this note was being written, the evidence that case and death counts were cresting was promising, fingers crossed! If the world can start getting back to work in May, and there’s not a case load relapse, given the amount of money authorities have thrown at the economy, it’s tough not to envision a strong bounce back in economic growth during the latter part of 2020.
However, two points merit mention. First, even with this optimistic scenario, most economic forecasts have fourth-quarter 2021 annualized GDP at levels below the levels of Jan. 2020. Second, the world will be a far more leveraged society than it is today, and that includes the consumer, hence don’t get too excited about the recovery.
It’s also important to understand what authorities have done. Fiscal stimulus programs that have been announced are merely designed to replace lost demand while monetary actions are attempting to stem a worsening of the current liquidity crisis. It’s as if the world economy has engaged in a leveraged buyout, shifting even more of the globe’s enterprise value to debt. The challenge with the heightened debt is that growth will remain constrained by unfavourable demographics and a leader of the western world who wants to reverse the efficiency benefits captured via globalization. So far the results of the cornucopia of programs have been mixed.
Still-elevated swap rates and various interest rate spreads suggest the plumbing of the financial system is improving but requires further attention. Seeing continued uncertainty priced into various segments of the financial markets that the average investor doesn’t watch day-to-day, such as U.S. dollar-euro swaps or spreads in the mortgage-backed securities or municipal bond market, the U.S. Federal Reserve has continuously announced additional measures in an attempt to ensure the system thaws versus freezes.
It’s likely that further improvement in these elementary segments of the markets will be forthcoming thanks to the US$450-billion injection the Fed will receive from the U.S. Treasury’s Exchange Stabilization Fund (ESF). First introduced more than 100 years ago, the ESF allows the U.S. Treasury to intervene in the economy in any manner that it sees fit to do so. The Fed has the capability to leverage this US$450 billion by a factor of ten and the funds will enable the Fed to lend directly to businesses or purchase debt in either primary or secondary markets. It will also allow the Fed to take more credit risk, though for now it’s just in the investment grade market: in other words, no high yield credit or collateralized loan obligations.
One particularly interesting recent move saw the Fed offer repos to other central banks. This action made us wonder whether the Fed offered this facility to try and prevent foreign central banks from selling U.S. Treasuries or to stem the rise in the U.S. dollar — or both. Remember, the JP Morgan emerging market currency index sits at an all-time low, down 13 per cent year-to-date, while U.S. dollar-denominated debt issued by non-U.S. issuers stands at an all-time high of more than US$12 trillion.
Of course if it takes longer to get the economy on the path to recovery, then additional fiscal support will be required and the Fed’s actions will need to shift from managing a liquidity crisis to a solvency crisis. Such a development would not be good for risk assets, but for now, let’s leave this scenario on the shelf. However, since it is easier to shut down versus restart a business (think about the supply chain issues) the timing of the recovery implicit to the more optimistic scenario is more back-ended during 2020 than most economists are currently predicting.
What does this mean for earnings?
A sample of bottom-up (company by company) 2020 earnings per share estimates for the S&P 500 show the Bloomberg consensus estimate at US$156, while BMO strategist Brian Belski’s forecast sits at US$160 and Goldman’s David Kostin’s dart hits the board at US$156. These numbers are tough to accept given that 2019 EPS for the S&P 500 was $165. From a top-down perspective, Kostin sees EPS of US$110, as he expects sales to fall 16 per cent and margins to decline by 200 basis points.
So, then what does the recovery in 2021 look like: a V, a U, or an L?
For the reasons we’ve talked about in many previous commentaries, we do not foresee a reacceleration in the trend rate of Chinese economic growth. While it’s hard to imagine, Europe will come through this economic crisis in worse economic and political shape than the European Union was in entering this terrible event. As for the U.S., as stated earlier, the post COVID-19 fiscal announcements to date have been more akin to universal welfare. In addition, both the U.S. dollar and leverage throughout the system will be higher, and remember: there’s a presidential election on Nov. 2. Whoever emerges as president will face a debt-to-GDP ratio of 100 per cent entering 2021 and a Federal Reserve that owns debt equivalent to 50 per cent of the country’s GDP. By the way, it’s likely that the Fed’s balance sheet will hit US$10 trillion by the end of 2020 compared to $4.16 trillion at the end of February.
More questions: what will happen with U.S. President Donald Trump’s tax cuts? What about an infrastructure bill? Once again, after the wonky growth rates that will be tied to this crisis, our dart suggests trend growth in the U.S. is likely to be no higher than two per cent
Of course, unfortunately here at home, Canada’s story isn’t even that good. Compounded by a leveraged consumer and an energy sector teetering on the brink of bankruptcy, immigration and technology continue to be the two saving graces for our economy. However, little question our growth will trail that of our southern neighbours. Granted, it could be as a result of this being an election year in the U.S., but keep in mind the scope and magnitude of dollars being offered up via Washington’s fiscal programs dwarf current government plans here in Canada.
It’s for these reasons that we’ve repositioned our portfolios towards the U.S., specifically the technology and the consumer sectors. If an infrastructure bill comes to fruition we’d get interested in industrials beyond the near-term challenged, but still fundamentally strong housing sector. Financials are a tough call since many near-term issues are likely to plague material recoveries in their share prices including credit quality, loan growth and interest rates. However, beyond cessation of the expansion of COVID-19, which will enable the economy to re-start, bond yields need to move higher from their current recession- or worse-type levels so as to provide investors (beyond traders) confidence in getting long markets once again.
We’d argue that it’s important for financials to take a leadership role in that recovery, although expect technology to continue to be the place to be. However, before that can happen, that market plumbing has to be fixed.
Looking at other sectors, our funds are short energy as we believe it’ll take a while to address bloated inventory given current demand destruction of up to 30 million barrels of oil equivalent per day, or 30 per cent of daily global demand. Remember, unlike copper, corn or even gold, you can’t store oil in a parking lot. After the present flurry of OPEC+ news, and especially after any news-driven rally, we expect the oil quote to go lower. As for the questions we’ve fielded about natural gas, it’s true it’s poised to benefit from far lower associated gas production over the next twelve months. However, in light of the current excess supply of global liquefied natural gas, it’s too early to look at gas equities. Shifting to gold, the thesis to our now 18-month long position in gold stocks looks the best that it’s ever been.
Only semantics differentiate the current program that the Federal Reserve has embarked upon and the monetization of debt. Granted jewelry demand has softened in India and China, plus large central bank buyers in recent years such as Russia have ceased purchasing. However, this demand shortfall continues to be more than made up by investment demand via exchange-traded funds (up 10 per cent year-to-date) and gold coins. Total investment demand has increased an estimated 1,000 tons while consumer demand has fallen by roughly 500 tons. Short term, a strong U.S. dollar, renewed market volatility, and heightened net speculative length could account for the failure of gold to pierce resistance at US$1,700 per ounce, but it remains a staple of our portfolios.
As for the near term direction of broader markets, our team has had many active discussions on that front. Clearly, progress against COVID-19 will be the biggest catalyst for markets. However, it’s tough not to imagine that, in light of the degree of dislocation that’s collided with a financially leveraged society in a matter of six weeks, that equities can rocket past their 50 per cent retracement level approximating 2,800 on the S&P 500 without at least a degree of a near-term pullback. Consequently, for now, while we’ve added to the long book of each of our funds we’ve also added to the short book hence the higher gross exposures of the two funds.
Sincere best wishes from the team at Forge First that you, your colleagues and your loved ones remain safe in this very odd time that we all find ourselves in at this juncture.
