Have We Just Cancelled the Discount Rate?

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April 22, 2020
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Wednesday Wanderer’s Wonderings*

After this week’s fun and games in the Oil derivatives markets, we should not lose sight of the underlying pressures in the oil patch. While the oil price isn’t really minus $37 unless you are trying to avoid physical delivery to Oklahoma this week, it is extremely weak, and certainly at below $20 (Brent Crude trading at $18 this morning) it is too low to sustain the poor balance sheets of the US Fracking Industry, or indeed the Kingdom of Saudi Arabia, where the budget deficit as a percentage of GDP is heading for over 20%.

In the near term, as the Chart highlights, the Baker Hughes US rig count is already dropping sharply, at 438 and falling. This is of course cyclical, back in 2014, when Oil was over $100 a barrel, the US Rig Count topped 1600 and companies like Schlumberger traded at $116 a share. Now, just like the Oil price, they are below $20. As noted previously at low price levels the law of supply and demand  in Oil has tended to go into reverse as stretched balance sheets of the two biggest producers  – the US and Saudi Arabia – desperately require cash flow and thus will pump more as prices fall. Neverthess, we believe that a combination of reduced supply and a rebound in demand will, of course, restore some of this balance, but the medium term landscape is likely to change.

Chart 1: US Rig Count collapsing, Supply and Demand will rebalance…

Whisper it who dares to Elizabeth Warren and Bernie Saunders, but the Fed move to ‘support’ the illiquid high yield debt markets has effectively bailed out the fracking companies (remember we thought that Wall Street was underestimating the risk of a Warren Presidency to the bond markets when she said at the end of last year that she would ban fracking day 1). Likely then that they will be absorbed into the bigger Oil conglomerates sooner rather than later, with low cost debt to Big Oil funding the acquisition of the best production areas while the weaker stuff is absorbed by the Treasury through ultimate debt write off. Just like the CDSs and the housing market in fact.

This leads our Wanderer to wondering about the broader implications for capital markets. If big corporates can effectively borrow at a cost of capital not that different to governments and thus not that different to zero, then how should equity markets value shares? After all, if my current return on Capital is, say, 10%, and my cost of capital calculated by my Corporate Finance textbook is supposedly 9%, then the value I would place on a new investment new project will be vastly compared to if I price my cost of capital at basically zero. Have we just cancelled the concept of the discount rate?

In practical terms and put another way, are large corporates about to be given state backed funds to buy up smaller ones? If I am, to take a recent example LVMH, then I am actually getting paid by investors to borrow money in order to buy Tiffany (negative corporate bond yields) and even though their return on capital is lower than mine, the cost of the capital is now far lower and thus it still makes sense. So European investors, unable to hold equities themselves because of ‘risk’ are effectively paying LVMH to take that equity risk for them, requiring no return beyond holding on to their capital and LVMH are buying US owned assets with the proceeds.

In effect are we about to see a new wave of barbarians at the gate, but rather than being small raiders funded with Junk Bonds, they are establishment raiders – a form of State Owned Enterprise in all but name, backed up by government balance sheets and effectively quasi nationalising the stock markets? How will governments respond if the next stage of globalisation is Capital Acquisition of other countries cash flow yielding assets? The Japanese government basically ‘own’ the Japanese stock market already, while a lot of sovereign wealth and quasi sovereign wealth funds own large chunks of other countries’ infrastructure – especially in the UK. It’s the equivalent of collecting all the utilities in monopoly and then getting free loans from the bank to buy the distressed assets of other players. Until someone tips the board over and storms off that is (which is how monopoly always ends in my house)

*The Header Picture of ‘Wanderer above a Sea of Clouds’ to my mind captures the role of the Global Strategist. Taking a high vantage point to try and make sense of the big picture, his can occasionally see part of the landscape through a parting of the clouds. What is going on in one valley may have implications for those on the ground in another and vice versa. Wednesday Wander Wonderings are thus a collection of longer term thoughts as to what may be happening to the big picture.

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Political Cicadas - no change in the product, just the sales team

The habit of spending long periods underground before re-emerging is not limited to the Cicada, for while this year sees the coincidence of the 13 year year Cicada cycle and the 17 year one, something that last happened 221 years ago, it is also 17 years sine Tony Blair was last in power and 13 since Francois Holland (likely PM in the French Hung Parliament) was. Both now look to be re-emerging to ensure continuity of policies that never really went away. The key sources of protest across Europe - crippling expensive wars against Russia and Climate change as well as uncontrolled immigration have only been addressed in the doubling down - the first thing UK PM Starmer did was fly to Washington to offer more money to NATO, while his Chancellor promised more money for Net Zero. Meanwhile, the left alliance put together to thwart Le Pen is even more pro immigrant than Macron. For markets, there is no prospect of lower spending and every prospect of higher taxes - the only 'Change' visible but not the one promised. The Technocrats and Globalists expecting this 'democracy' means that the populous will go quietly will be disappointed, especially with the arrival in the Autumn (once the Cicadas have gone) of the great populist, anti open border, anti net zero and anti war populist Donald Trump.

Market Thinking July 2024

The scorecard for the first half puts Equities, commodities and Gold in the top half of the table, with cash and fixed income in the lower half. This is consistent with the steady but uninspiring macro backdrop and positioning ahead of a tricky H2 from a political perspective. The anomaly of the Market Cap weighted SPX out-performing the equal weighted SPW by over 10% points tells us both that the SPX is no longer telling us anything about the US economy and that this excess return is for taking (considerable) concentration risk. Meanwhile, with Bond analysts 'pivoting from the Pivot' the fixed income markets have calmed down a little and leaving The Donald' rather thna 'The Fed' as likely the biggest policy influence on Markets over the next 12 months. In particular, we would look out for a 'Trump Plaza Acord" early next year, 40 years after the last one- something the FX markets aren't talking about, but the asset allocators seem to be (at least subconsciously) pricing in.

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