Newsletter April 12, 2020
The State of the Markets
The S&P 500 crashed hard due to the coronavirus fears and the growing economic shutdown. After bottoming on March 23 it then staged a very large rally based on truly massive government financial aid to both consumers and businesses including massive central bank support for the banking sector. The rally was also helped and extended by indications that the peak of the virus situation may be at hand and assurances from some (Including President Trump) that the economic shutdown will soon begin to be lifted.
As of Easter weekend, the S&P 500 is down 14% and the Toronto stock exchange index is down 17%.
In my view the 14% decline in the S&P 500 seems almost modest compared to the situation we are in. Even in a best case scenario, the North American economy at the end of 2020 is almost certain to be operating a lower level than it entered 2020. Unemployment seems certain to be materially higher. Caution about the direction of stock markets therefore seems in order.
Oil Markets – Bad news
The world was recently consuming about 100 million barrels of oil per day. With the economic shutdown consumption has apparently dropped by something in the order of 30 percent or 30 million barrels per day.
Quite naturally, the laws of supply and demand kicked in and sent the price of oil plummeting.
On top of that the OPEC price-fixing cartel which normally uses production quotas to keep some of the lowest cost barrels of oil off the market and therefore artificially boost prices which benefits all oil producers world wide has largely collapsed as Saudi Arabia has increased production in some kind of a market share battle with Russia. There is also a theory that OPEC has purposely increased production at this time of low oil prices in order to drive western world producers permanently out of business. Whatever the reason for it, the collapse of the OPEC quota system has pushed oil prices even lower.
If demand for oil has indeed fallen by some 30 million barrels and if at the same time Saudi Arabia and other OPEC members with its low-cost oil have actually boosted production then it follows that the rest of the world must have cut production by even more than the amount of the demand reduction. (Well, for a short time the cut may not be quite that deep with the excess going into storage but the storage would soon be filled to capacity which soon forces the production cuts).
Over the Easter Weekend OPEC is trying to reach an agreement to curtail production by 10 million barrels per day. The oil producers in the rest of the world represented by the G20 countries would dearly love to see OPEC make that cut. If they did it then the rest of the world would only have to cut by an estimated 20 million barrels rather than 30 million barrels per day. Apparently OPEC would like the G20 to agree to also make some oil productions cuts.
I find it rather strange indeed to suggest than the G20 countries agree to oil production cuts. First, if demand is down some 30 million barrels per day then huge cuts must already be automatically occurring outside of OPEC – either that or the storage facilities must be filling up fast and about to over flow. Second the great majority of oil production outside of OPEC is not owned by governments but by private corporations. Admittedly, Alberta has mandated production cuts by private corporations since the start of 2019, but that was a rare intrusion.
If I understand the situation correctly then OPEC as the low cost producer would normally not have to cut production in response to lower world demand. The simple and sometimes brutal laws of supply and demand work to automatically force the higher cost producers in the rest of the world to reduce production by the full amount of the drop in world demand (setting aside a short delay until all storage capacity is filled). An OPEC cut by 10 million barrels would be greatly welcomed by oil producers in the rest of the world and would push prices up somewhat. Any agreed cuts by the G20 would seem to be purely symbolic in that those cuts must automatically be made under the rules of supply and demand. If world demand is down by 30 million barrels per day then world production must fall by that amount and whatever does not occur in OPEC must occur in the rest of the world.
My conclusion is that as long as oil demand is down by some 30% or 30 million barrels per day then oil prices will continue to be very low. A 10 million barrel per day cut by the low cost producers in OPEC would push the price somewhat higher but nowhere close to pre-economic-shutdown levels.
Furthermore the laws of supply and demand dictate that it is the highest marginal cost producers that must bear the brunt of production cuts. Unfortunately that probably includes the Alberta oil sands especially when the cost of transportation to markets is factored in.
And, unfortunately for oil producers and all who profit from the industry, when the economic shutdown ends, oil demand cannot be expected to return to 100 million barrels per day. Cruise lines and Airlines will certainly not return to the old consumption levels anytime soon. Higher unemployment and perhaps the newly discovered ability to work from home will reduce gasoline demand. Western oil producers, although they don’t like to admit it, will continue to be reliant on the OPEC cartel operating to push world oil prices higher. But with lower demand for oil, prices are unlikely to recover nearly as much as the industry would hope.
Comments on Asset Allocation
Individual investors have different asset allocations across the major asset classes which are equities, fixed income and cash. They also have different allocations across geographies. And the equity and fixed income asset classes can both be divided into many segments and ultimately into individual stocks, bonds and other securities.
Historical data confirm that over longer periods of time such as 30 years a 100% allocation to equities has provided the highest returns but also features periods of truly gut-wrenching declines. The most conventional advice is for most people to take a balanced approach featuring about 60% equities and 40% fixed income. This has historically produced returns somewhat lower than an all-equity approach but has also greatly reduced the depth of the declines in bear markets.
It turns out that a balanced and well diversified portfolio would have been a very good strategy entering 2020. For example the Vanguard balanced portfolio VBAL is down a comparatively modest 7.4% in 2020 to date.
My analysis has focused heavily on individual equity stocks. And those stock picks have beaten the market over the long term. But that has not been the case recently. In my October 15, 2017 newsletter as well as in other articles on this site I have been very upfront about the difficulty of beating the market index through investing in individual stocks.
My most recent previous newsletter dated September 29, 2019 explained exactly how to invest in a balanced and well diversified manner by simply buying the likes of VBAL or VGRO or creating a balanced portfolio from a list of exchange traded funds. It turns out that was timely advice if anyone took it. (I did not.)
At this time investing some or even all of a portfolio in something like VBAL or VGRO may continue to be a good approach. I think a heavier than normal allocation to simple cash could also be a good strategy at this time. If the market begins to forecast that the world will come of this situation with a 2021 GDP level several percentage points or more below that of 2019 and with significantly higher unemployment, not to mention the higher government debt levels, then certainly markets could fall from current levels.
Should Contract Enforcement Be Suspended?
I am disturbed by any suggestion that individuals and even large corporations should be entitled to simply refuse to pay their rents and leases and mortgages during this crisis.
Apparently, Canada’s largest banks are financially in a position to allow six month personal mortgage deferrals. I am okay with that although concerned about the longer term impacts on both the banks and their customers.
But suggestions that people and, even large corporations, without an agreed deferral from their bank or landlord simply refuse to pay are disturbing.
Our entire economic system relies on the trust that financial obligations will be met. Money circulates constantly. If you stop the flow of money to banks and certainly to building owners then those banks and certainly building owners will soon become unable to meet their own financial obligations.
For many years now a relatively strong economy with relatively low unemployment combined with an easy ability to borrow, has meant that the great majority of financial obligations have been met. There are always some bankruptcies and delinquencies and bad debts, but these have been relatively minor. Businesses have been able to rely on other businesses and consumers to meet their obligations.
In the current situation many people are suddenly unemployed. And many businesses are suddenly closed. The government has greatly mitigated this with new emergency cash payments to individuals and businesses although much of this cash will take some weeks to start flowing. In my view, both businesses and individuals should be strongly encouraged to meet their obligations if at all possible. And if they don’t have the cash then they should tap any available borrowing sources to meet their obligations. They could also politely ask for, but not demand, some relief from their lenders and/or landlords.
The alternative of suggesting that businesses or individuals should simply temporarily renege on their obligations would be a huge affront to the idea of the enforcement of contracts and the trust that is absolutely central to our economic system. It will be much more difficult for the economy to ever return to normal if that trust is much diminished.
April 12, 2020