Iran real beneficiary of Russia-China gas deal and more on overheated markets
The big news today is the Gazprom deal in China. This is a $400 billion gas deal to supply gas from Russia to China for 30 years that has been in the works for over a decade. But the changing geopolitical atmosphere has given it urgency. Overall, from a macroeconomic perspective I am positive. But risk has really increased. And the Russell 2000 is one of the areas where you see the biggest overvaluation. We see it in high yield as well.
The big news today is the Gazprom deal in China. This is a $400 billion gas deal to supply gas from Russia to China for 30 years that has been in the works for over a decade. But the changing geopolitical atmosphere has given it urgency.
Russia and China are strengthening ties as the relationship with the US for both countries has deteriorated, much more so for Russia than China. According to media reports, Gazprom will invest $55 billion in gas exploration and pipeline construction, while the Chinese will contribute $20 billion to the deal.
The agreement is for 38 billion cubic meters of gas per year for 30 years, according to Gazprom CEO Alexey Miller. Supplies won’t start for four to six years. Now, Russia is a big producer. But this is a huge volume of gas to produce. Chris Martenson was on Boom Bust yesterday and he says it is clear that Russia cannot deliver that quantity of gas to China and continue to supply Europe with the same amount of gas. His view is that a cutback in gas supplies to Europe from Russia is likely.
The question then becomes: where is Europe going to get its gas then? Logically, the answer is Iran.
According to the Iran Petroleum Ministry, Iran has proved reserves of 29.6 trillion cubic meters. That’s just under one-sixth of the world’s total reserves. SO Iran is a big player in natural gas and that means Europe will want rapprochement with Iran now that this China-Russia deal has gone through. In my view, this puts a wedge between the US and the EU because not only is the aggressive US policy toward Russia raising tensions and causing Russia to pivot toward Asia. But, the US policy toward Iran also creates severe difficulties for the EU if it wants to lock in another gas supplier.
For me, the big story here then is Iran and Europe, not China, Russia and the US. It is unclear what economic impact this developing geopolitical shift will have. However, I think we need to watch Iran and how the EU, Russia, China, India and Brazil, in particular, deal with Iran.
On another unrelated issue, the Russell 2000 has been hit hard over the last few weeks and has hit official correction territory. It’s high was 1212 on 4 March. It is now trading just below 1100. I mentioned on 9 May that we were seeing a dichotomy in US markets that pointed to increasing risk. On the one hand, the Dow Jones was holding up well. But the Nasdaq was down with a wedge pattern that gave some support, while the Russell 2000 of smaller and mid-cap companies were in a downward channel which was bearish. Christopher Wood sees the potential for a correction in the broader market.
The problem here is that the small- and mid-cap companies had been leading to the upside. Smaller and mid-cap companies are more sensitive to economic shifts. So investors should see the decline in the Russell 2000 as ominous for the equity market as a whole. The Russell 2000 was the first to soar in 2009 and has more than tripled from lows in March 2009.
So the bifurcation in the market says that leadership has gone away. Investors are not pulling out of the market. Rather, they are rotating into defensive shares and this has buoyed the braoder S&P and the Dow. But, I see this move to defensive positioning as indicative of a market that is not going to see any more multiple expansion until the Russell 2000 can re-confirm the upward trend. This may be a consolidation phase as investors seek dividends over growth. If the real economy can continue advancing, we could see shares march higher after consolidating.
My overall macro view is upbeat. Nothing I see in the US points to recession and Europe looks like it will continue to benefit from a basing effect in the periphery, though the situation remains at stall speed. Overall, from a macroeconomic perspective I am positive.
But risk has really increased. And the Russell 2000 is one of the areas where you see the biggest overvaluation. GMO’s 7-year asset class forecast is deeply negative.
What are bond markets saying here? They are still amping risk.
The average yield companies paid to raise long-dated debt fell 59 basis points worldwide to 4.4% according to Merrill. Companies and countries are locking in low rates for bond deals out to 100 years. Hasbro, a toy maker recently sold 30-year paper. Caterpillar sold a 50-year bond. Electricite de France and Mexico both got 100-year deals off. And remember that 17 years JCPenney issued a 100-year bond because, apparently, it was a solid company that would last for 100 years. That was 1997, as the US entered a mania and people didn’t think twice about JCPenney’s being a retailer in a changing global environment.
In high yield, the chase is on. Triple-C rated companies are trading at record low yields. Yesterday, Merrill had the average yield on Triple-C paper at 8.817%. And the Wall Street Journal mentioned a number of LBO deals coming to market at low coupons despite record EBITDA deal multiples. 40% of US private-equity deals this year have been over six-times EBITDA , according to S&P Capital IQ. That’s the highest since the 52% we saw in 2007, just before the credit bubble collapsed.
What’s going on here is that investors are reaching for yield by moving out the risk spectrum to long-dated paper in order to get yield pick up. Just as the JCPenney deal demonstrates, these deals are fraught with risk, even if the issuer seems solid. I anticipate serious losses down the line in certain cases: think Hasbro for 30 years.
The real economy says this risk-taking can get worse. But we are already at extreme levels and all of the telltale signs of an overheated credit environment are mounting. Any move higher from here makes the situation that much more overheated. A correction would be nice. But I have no conviction it will lead to a permanent shakeout of risky investing. Likely, we will see an escalation of risk until the real economy turns down.