Natural gas and the strong dollar as headwinds into 2015

Yesterday, I planned to write this piece as a compilation of narratives for individual countries in the global economy: India, the US, the UK, Spain, etc. However, some of these narratives are more useful than others. So I am going to lead with the US narrative and see how far I get. In particular, I want to start off with some comments by Stephen Roach and put them into the context of a US economy that expanded at an annualized 5% rate in Q3.

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Yesterday, I planned to write this piece as a compilation of narratives for individual countries in the global economy: India, the US, the UK, Spain, etc. However, some of these narratives are more useful than others. So I am going to lead with the US narrative and see how far I get. In particular, I want to start off with some comments by Stephen Roach and put them into the context of a US economy that expanded at an annualized 5% rate in Q3.

Here’s the broad view about the US as I see it. The U.S. economy overall is doing well, much better than most any other developed economy. At the moment it is well above a stall speed below 2% annualized growth and breaking away from trend growth of a rolling 12-month growth rate in the 2 to 3% range, that I have been calling 2%ish growth. Yes, the oil (and potentially the natural gas) capital investment boom presents a 1% headwind going forward into 2015. But, given the overall momentum, that is not enough to derail the U.S. economy in my view. More likely, we will see U.S. monetary policy normalization.

US quarterly GDP growth

Source: Financial Times

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The U.S. economy has created an average of 240,000 jobs for the first 11 months of 2014. The unemployment rate is below 6%. Average initial weekly jobless claims are below 300,000 and we have seen the best quarterly and half-year growth rate in the U.S. since 2003. Under every conceivable realistic macro view, knowing that monetary policy acts with a considerable lag has to force the Fed into rate hikes next year. If the economy remains even remotely on this path next year, I believe we will see the first rate hike in June.

Yet, I remained concerned both about the methods used to prop up this economy and about the underlying fragility of the economy despite the headline figures. Let me bring Stephen Roach in here to make my case with a segue via Market Watch.

Here’s Market Watch: Headline: “Dow 18,000 has most Americans feeling good about 2015

Wharton finance professor Jeremy Siegel sure seems to have the holiday spirit. And why wouldn’t he? He’s still alive, has some hair left and his Dow 18,000 call from last year just came up roses. He took to Bloomberg on Tuesday to savor it.

And, not to push his luck, he also said he’s standing by his 20,000 call for 2015.

“The bull still has room to run, but we are much closer to fair market value certainly than we’ve been any time in the last five years,” he said, adding that the decline in oil and a continuing low-rate environment will provide a stiff tailwind through at least the first half of the year.

Somebody must have spiked Siegel’s gingerbread cookies. At least that’s what guys like Stephen Roach, the former Morgan Stanley Asia chairman, are probably thinking.

“With so much dry kindling, it will not take much to spark the next conflagration,” Roach said in his latest missive on the Fed’s epic blunder.

Judging from a recent tally, most of us would be more apt to side with Siegel in terms of shared optimism. For the first time in seven years, a majority of Americans — 51% — has a positive view of the economy, according to the latest CNN/ORC poll. That’s a big bump from 38% in October.

And, of note, it’s not the 1% — or even the 25% — who accounted for the most of the rise. It’s those Americans making less than $50,000 annually. There you have it: a merry Christmas to us all.

I’m sorry but this is utter rubbish, absolute nonsense. Middle class Americans are not elated because the market is up. The market is not the economy. The reason ordinary Americans are feeling better about the economy is that real disposable earnings are finally increasing due to the decline in oil prices. This, combined with job creation means that economic growth is finally trickling down to the middle class, 5 years into this recovery – and just in time for the Fed to hike interest rates.

But then there is the Roach missive which Market Watch alludes to – and dismisses. I cribbed it from Project Syndicate. Here are the important lines:

Central banking has lost its way. Trapped in a post-crisis quagmire of zero interest rates and swollen balance sheets, the world’s major central banks do not have an effective strategy for regaining control over financial markets or the real economies that they are supposed to manage. Policy levers – both benchmark interest rates and central banks’ balance sheets – remain at their emergency settings, even though the emergency ended long ago.

While this approach has succeeded in boosting financial markets, it has failed to cure bruised and battered developed economies, which remain mired in subpar recoveries and plagued with deflationary risks. Moreover, the longer central banks promote financial-market froth, the more dependent their economies become on these precarious markets and the weaker the incentives for politicians and fiscal authorities to address the need for balance-sheet repair and structural reform.

A new approach is needed. Central banks should normalize crisis-induced policies as soon as possible. Financial markets will, of course, object loudly. But what do independent central banks stand for if they are not prepared to face up to the markets and make the tough and disciplined choices that responsible economic stewardship demands?

The unprecedented financial engineering by central banks over the last six years has been decisive in setting asset prices in major markets worldwide. But now it is time for the Fed and its counterparts elsewhere to abandon financial engineering and begin marshaling the tools they will need to cope with the inevitable next crisis. With zero interest rates and outsize balance sheets, that is exactly what they are lacking.

And a Merry Christmas to you too!

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Here’s what Roach is saying that I agree with: We are not in a financial crisis right now. Quantitative easing is a financial crisis policy. The Fed acts as lender of last resort by expanding its balance sheet, swapping new base money with existing financial assets in markets lacking liquidity. That is what the Fed did in QE 1. However, every subsequent large scale asset purchase program was initiated simply because the Fed had run out of runway on its interest rate policy lever and needed to somehow fulfill its congressionally-legislated mandate of supporting full employment. Roach is saying this is a dangerous approach to monetary policy because it artificially boosts asset prices (in an unsustainable way), leaving the Fed to normalize policy very late into an economic cycle, leaving it with even less runway to counter another credit downturn down the line.

We are seeing the effects of the Fed’s machinations in the bond market, where private portfolio preferences have been skewed by low nominal rates, forcing the risk-seeking-return crowd farther out the yield curve and into riskier asset classes like junk bonds emerging market debt and leveraged loans. I have talked a lot about high yield and leveraged loans. So I want to mention the emerging market problem briefly. Now, think about this for a second. You’re an American or European fund manager and you know the developed economy and many developed economy corporate balance sheets. You feel fine investing in Treasurys, Bunds, and high quality corporate bonds from Western Europe and North America. But these assets are providing you with very little yield. Now, you also know didley squat about the balance sheets of most emerging market companies. But so what? Why not get into the better known names, offering higher yields than their North American counterparts and a potential pickup due to huge growth in emerging markets.

Here’s my question: if you’re going to get into the emerging markets, why would you buy corporate bonds with default risk, unknown company risk and unknown country risk? Yes, you are no longer subject to currency risk but if the emerging markets turn down, the currency risk becomes manifest as default risk as the corporate balance sheet suffers. And then you take huge losses. I think this is what is going to happen here, that a strong dollar is going to catch out EM corporate debtors borrowing in dollars and turn their balance sheets upside down as their liabilities remain fixed in dollar terms while their asset base and revenue stream decline in dollar terms.

5% annualized growth and 240,000 jobs a month are making policy divergence not just a possibility, but a probability. The U.S. will hike rates due to the improved U.S. economy. And given the ongoing decline in Chinese growth and capital intensity, this should put downward pressure on commodity prices in dollar terms. That is toxic for emerging market currencies and emerging market borrowers. Hot money flows will exacerbate this problem. And so EMs need to think about ways to prevent crisis without being forced to hike rates to onerous levels as Russia has done. They are the canary in the coal mine.

In the U.s., the problems in the oil patch have long ago infected high yield and leveraged loans as I feared. My new fear here is natural gas. If you have been watching natural gas prices, they have been falling. And this week they have been absolutely crushed. Here’s the Wall Street Journal:

Mild temperatures across the U.S. have sent natural-gas futures tumbling to their lowest level in nearly two years, more good news for consumers already reaping the benefits of a 30% decline in gasoline prices.

Natural-gas prices dropped 9% Monday, their largest decline since February. It extended a losing streak to three sessions since the government said gas stockpiles rose above year-ago levels for the first time in 2014.

Record U.S. oil-and-gas production, which has played a major role in driving the 48% decline in crude prices since June, is overwhelming tepid demand for home-heating fuels amid an unseasonably warm December.

Many investors who earlier this year placed bets on rising gas prices have had to reverse course and cover those bets, as strong production has now closed a stockpile shortage that had lingered for nearly a year.

I would consider this contagion. Yes, the proximate cause of the sell off is warmer temperatures. But fuel switching between oil and natural gas was always going to put pressure on natural gas prices. Now that natural gas prices have fallen, we should be asking: where to next? My understanding is that the weather forecasters in the U.S. have put the odds of an El Niño winter in the Northern Hemisphere at 65%. And this should mean a mild and dry northern half of the U.S., where the demand for heating oil is greatest. Given the lack of LNG facilities in the U.S., that means U.S.-based natural gas is going to be abundant and prices will be under further pressure. I believe this will be a killer for the shale industry because it means both the oil and natural gas side of their asset base will be under assault. Moreover, many of these companies have not hedged. Devon Energy is hedged into 2015. But companies like Continental Resources are largely unhedged. And many of the more precarious, leveraged tpes will feel lots of pain as a result of both the decline in price and the concomitant freeze in funding.

Yves Smith has a post up on Naked Capitalism talking about this and the biggest takeaway here goes to the PE firms behind a lot of the funding in this space:

It’s hard to imagine an industry that is a worse candidate for private equity than oil and gas exploration and production. The prototypical private equity purchase is a mature company with steady cash flow. Oil and gas development is capital intensive and the cash flows are unpredictable and volatile, because the commodity prices are unpredictable and volatile.

A less obvious issue is that it actually takes a lot of expertise to run these businesses. This is not like buying a retailer or a metal-bender. Now private equity kingpins flatter themselves into believing that experts are just people they hire, but here, the level of expertise required, and the fact that the majors are way bigger than private equity firms means that the private equity buyers don’t know enough to vet whether the guy they hire is really as good as he says he is. Like all outsiders, they are way too likely to be swayed by the sales pitch and personality rather than competence.

Read this piece because it has a great anecdote from a PE insider who was surprised at how unprofitable these companies are. This is a big landmine waiting to explode.

My sense here is that this is the inevitable consequence of trying to prop up an economy using a monetary policy-heavy approach of low interest rates and large scale asset purchases. The Austrians are dead on here when they talk about capital allocation as the cause of much pain when the credit cycle turns down. The irony is that policy makers are focused on the last war, too big to fail banks and their excesses in mortgages. Clearly there are excesses but they are in different parts of the financial system now. Are regulators attuned to these problems. I doubt it.

Coming full circle here, I did not get to my country analysis unfortunately. However, you can see my confidence in the U.S. recovery has a big caveat. The problem for the U.S. is not just that resource allocation is skewed in a very dangerous way and monetary policy space is limited due to zero rates, it is that the policy choices have also skewed the benefits of recovery, increasing the underlying fragility of it. Wage growth is weak and the big change in real disposable income is now only coming from a slide in oil prices, and potentially natural gas prices. While the decline in oil prices is positive for the economy via a decrease in costs for consumers with the largest marginal propensity to consume, it has been so abrupt as to expose us to a potential financial crisis. 

The goldilocks scenario for 2015 is a pause in the oil and natural gas price decline followed by a modest strengthening in prices just as the labour market tightens enough to push up wage growth. The downside risk is that the strong dollar and natural gas weakness add to a building crisis in higher risk assets that overwhelms the progress made so far. The Fed may feel it has had no choice but it has set itself a trap. We can only hope for the best.

Merry Christmas and safe travels this holiday season.

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