Friday Highlight Reel - Edition #6
A sampling of interesting observations from the Haymaker's network of market experts and favorite resources.
“Stuck in an endless cycle of Ponzi finance (as Hyman Minsky described it), the survival of the financial system now depends on its ability to refinance the debts it can never hope to repay.” -The Credit Strategist’s Michael Lewitt
#1: David Rosenberg on the Precarious Condition of Many U.S. Banks
“The Financial Times ran with a fascinating column titled The U.S. bank system is more fragile than you’d think and provided some mind-numbing data from research published by five researchers (Haymaker note: from USC, Northwestern, Columbia, Stanford and the National Bureau of Economic Research or NBER). The FT ran its own analysis and drew this conclusion: ‘The researchers argue that the U.S. banking system is a lot more fragile than commonly assumed…Prior to the recent asset declines all U.S. banks had positive bank capitalization. However, after the recent decrease in value of bank assets, 2,315 banks accounting for $11 trillion of aggregate assets have negative capitalization.’”
Haymaker Take: That ending stat is definitely an eye-opener. It actually synchs with a factoid I recently heard from banking expert Chris Whalen, who has been warning of the peril to banks from the Fed’s war on inflation. (Sorry, but I can’t help pointing out that the Fed let the CPI genie out of the bottle and is now frantically trying to get it back in there; inflation is not nearly as compliant as was Barbara Eden!) Chris flatly stated that, as of 12/31/2022, even mighty JP Morgan had negative equity on a fully marked-to-the-market basis. With many real estate sectors under increasing pressure, it’s hard to see how this doesn’t get worse… possibly much worse. Unquestionably, U.S. policymakers are going to pull out all the stops to avoid more bank runs. In my view, they’ll be successful. However, there will be a price to be paid – that cost will be structurally higher inflation after the initial disinflation a recession is likely to produce. (Please see Ray Dalio’s comments at the end of this Highlight Reel edition.)
#2: Goehring & Rozencwajg’s Leigh Goehring re: The Planet’s Extreme Reliance on Texas’s Permian Basin to Meet Its Oil Needs
“The Permian is still growing. So we still have some growth in the Permian left. However, think of it this way. The entire global oil industry, as far as its growth, is now dependent on basically six counties in West Texas. That's the only growth that's taking place in global oil supply today. Everything else is either plateaued or in the process of decline right now. So once the Permian actually begins to decline, then all of a sudden, where is the next great source of oil supply growth going to come from?”
Haymaker Take: Though I hate to quibble with one of the oil mavens I respect most, there are a few areas around the world where crude output is expected to increase… a few. The Canadian oil sands and offshore Brazil and Suriname are exceptions. Overall, however, he’s spot-on. And, as noted earlier this week in Making Hay Monday, even the prolific Permian is beginning to show its age. As discussed in that piece, the Permian is by far America’s highest-volume producing region. But it is also a shale formation, meaning it experiences extremely fast decline rates, unlike with conventional oil production. His ending question doesn’t have a good answer. This is notwithstanding that one of my Three Wise Oil Men – personal friends who’ve been highly successful for decades in the energy industry – believes the Permian is so immense that there are still great reserves to be discovered.
As a footnote, another pointed out that I was too conservative in my statement in Monday’s note that most other fields have only one or two payzones. He said in some cases there can be as many as four. Regardless, the Permian is in a class by itself when it comes to its depth, which, according to Enverus, is “as shallow as hundreds of feet below the surface to as deep as five miles…” (For reference, that maximum depth is equivalent to the height of over 21 Empire State Buildings.) Basically, as the Permian goes, so goes U.S. oil production.
#3: Evergreen on High-Yield Credit Spreads
Per Jeff Dicks, Evergreen Gavekal’s Co-CIO: “A few interesting factoids would be that high yields spreads widened by 74 basis points (0.74%) over a two-day span starting March 9th. This was the largest move excluding Covid over the last decade. Bank preferreds widened by 110 basis points (bps) also the largest move excluding Covid. The FRA/OIS spread which is used to gauge U.S. banking sector stress jumped nearly 52bps on Monday March 13th, which was the largest one day (rise) in 15 years and a larger move than any day during the Global Financial Crisis (GFC). HY spreads at +500 (i.e. 5% above U.S. government bonds) are tighter than the 20-year average of +533. To simply move back to the peak in 2011, or 2016, the metric would have to move to +900. If you look back to 2011 and 2016 that would represent a downside of around 10% more on high yield bonds.” (Another Haymaker note: this is on a total return basis, including the positive offset from the yield).
Yield differential (spread) between treasury and high yield (junk) bonds over the past year:
Yield differential (spread) between treasury and high yield (junk) bonds (last five years):
Haymaker Take: Numerous Haymaker editions have repeatedly emphasized the extreme importance of credit spreads, as did my predecessor publication, the Evergreen Virtual Advisor (EVA). Lately, they’ve been rocketing, as Jeff notes. This is sending out an SOS that is the polar opposite of the stock market’s nonchalance (at least outside of financial and energy stocks). As my bright colleague Jeff points out, despite this recent dramatic widening, spreads remain at a moderate level. The positive interpretation of this is that the current banking turmoil isn’t a major risk. The negative take is that there is much further widening up ahead. While I lean toward the latter view, there’s no doubt that much of the spread surge has been a function of banking-related bonds tumbling in price, jacking up their yields. However, recessions also cause significant spread expansions. Because I believe banks are now almost certain to be much stingier in their lending activities, I’m sticking with my anticipation that a U.S. recession is also a near certainty. The good news is, as Jeff outlines, even a pop to a spread of 900 bps (9%) over government bonds would lead to an additional 10% loss on junk bonds. That’s not a pleasant experience, but it’s not a disaster, either.
To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.
#4: Deutsche Bank’s Jim Reid on the Similarly Shocking Move in Two-Year T-Note Yields as a Result of the Banking Crisis
“As we approach the end of one of the more fraught weeks in financial markets since the GFC, Henry Allen and I have published 10 charts from an unprecedented week in markets…Perhaps the stand out has been the 2yr notes on both sides of the Atlantic, with US yields seeing the largest daily fall since 1982, and German yields seeing the biggest decline in available data back to reunification in 1990.”
Haymaker Take: The yield collapse in the two-year T-note was truly epic. The key question now is if conditions in the bond market will soon settle down. A related development has been the vertically asymptotic (i.e., straight-up) move, appropriately, by the MOVE Index (see below), the bond market equivalent of the stock market’s much better known volatility index, the VIX.
MOVE Index
Frankly, it’s remarkable these extraordinary bond market events can be happening at a time of such stock market resilience. Basically, bond behavior is strongly suggestive of tough economic times while the stock market has clearly not received the memo. However, it is fair to note that even with stocks money seems to be flowing into the perceived safehaven of mega-cap tech companies, with their fortress-like balance sheets. A growing number of more cyclical enterprises seem to be picking up at least the scent of a recession.
#5: BofA’s Top Investment Strategist, Michael Hartnett, on Yield Curves
“US 2s 10s yield curve most inverted since Feb ’82; inversion best lead indicator of recession past 50 years, but steepening is best indicator has begun and “pivot” imminent.”
Haymaker Take: Chalk this up to another way-outside-of-the-box bond market development. They just seem to keep coming. In fairness, Michael wrote these words last fall, but they seem to have been prophetic, as his prognostications often are. This is because, lately, the aforementioned plunge in the two-year yield relative to the 10-year has created a dramatic un-inversion of the interest rate curve (though it remains upside down or inverted). As he noted, the degree of inversion in this regard was the most extreme since the days when Paul Volcker was ruling the Fed and vanquishing inflation. Perhaps the curve will soon move back into a deep inversion, assuming the bank panic deescalates. However, should overall economic conditions begin to more closely align with the increasingly recessionary leading indicators, another rapid drop by short rates vis-à-vis longer ones will ensue. If so, a steepening, or un-inversion, of the curve becomes nearly fait accompli.
#6: Bridgewater Founder, Ray Dalio on “Real Returns”
“The really big problem will come when there is too much of this money printing to provide creditors with adequate real returns, which will lead them to start selling their debt assets, which will substantially worsen the supply/demand balance. With the enormous size of the US debt assets and liabilities outstanding, plus lots more to come, there is a high risk that the supply of government debt will be much larger than the demand for it, which will cause too-high real interest rates for the markets and the economy, leading to debt and economic pain that will eventually lead (the Fed) to switch from raising interest rates and selling debt (QT) to lowering interest rates and buying debt (QE)...So, it looks likely to me that the financial/economic picture over the next year or two will be tough.”
Haymaker Take: Ray Dalio is not only a multibillionaire, the flagship hedge fund he founded some three decades ago has generated extraordinary risk-adjusted returns since inception. Along the way, he has developed a reputation for being one of the investment world’s most perceptive big-picture thinkers. Accordingly, I thought a quote from him summarizing the current environment would be an ideal way to end this Highlight Reel edition. The above comments explain why I feel we could see a very unusual – and very unfortunate – set of conditions, causing interest rates on longer-term government debt to rise even in a recession. If so, I agree with him that the Fed will have little choice but to restart its Magical Money Machine, otherwise known as Quantitative Easing (QE). This is the photographic negative of its current Quantitative Tightening (QT). In my view – and, implicitly, in Ray’s – the shelf-life of QT is likely to be brief, as it was the last time the Fed tried to meaningfully shrink its balance sheet. Once the Fed shifts gears, risk assets, like stocks and commodities, are likely to rip higher. The tricky part is how low they fall, particularly equities, before the Fed reverses course. For now, earning 4½% in a government security money fund is hard to beat, although there are already some interesting bargains emerging with stocks, corporate bonds and hard assets.
My observation when taking all of this into account is that people seem to see binary outcomes. Either the markets crash or there is a crack up boom / good times forever and ever. But the world is non linear. What if we end up in stagflation. Low growth and stubbornly high inflation? What if we have finally reached the limits of where QE can take us? QE only works in a low interest rate low inflation world. What if we are now leaving that world behind and replacing it with a geopolitical nightmare?
QT to QE...Luke Gromen has been all over this in his weekly Tree Rings. Let's watch.