Wir sind alles Metallgesellschaft

An unhappy meeting of finance and industry

The behaviour of the price of oil in the last week was, to understate the matter, jerratic. A sharply negative oil price (the first time since 1870 at least) in the May contract served to illustrate how topsy-turvy the economic world has become (I hope some airlines hedged in negative oil!). Together with the relatively recent advent of negative interest rates, negative oil prices will convince many that something is not right in the engine room of the global economy.

I mentioned in last week’s missive that assets like oil that did not fall under the spell of central bank asset purchases gave a truer indication of the economic outlook than those assets that did.

In this context, the signal sent by the price of oil, even today, should be a cause for concern. Of course, other factors conspired to push oil into negative territory – notably a shortage of storage, the convince of some hedge funds and traders as well as the side effects of financial engineering (exchange traded fund (ETF) structuring).

This upside-down oil shock is not over and the effect of low oil prices will continue to ripple through emerging and high yield debt markets, emerging market currencies and the dollar, as well as banks and the Texan economy.

In the greater scheme of things, it also brought to mind the case of Metallgesellschaft, a giant German industrial conglomerate which in 1993 ran up a USD 1.5bn (a lot of money then) loss on an oil hedging contract. Metallgesellschaft fell foul of the same effect we witnessed last week, contango, where the price of near dated contracts (i.e. May) dropped well below the level of later dated contracts (e.g. July).

The Metallgesellschaft case left a mark on the financial economic history of the early 1990’s and is widely taught in business schools as a case study in the dangers of mixing business and financial engineering.

The collapse of Metallgesellschaft came at an early point in the deployment of derivatives in markets and should have served as a salutary lesson to corporates, regulators and banks. That was not the case.

For instance, the lesson that Deutsche Bank, which had arranged the hedging trades for Metallgesellschaft, apparently drew from the blowout, was to aggressively expand its investment banking operation. Today, the share price of Deutsche bank is down 95% on the level it reached before the global financial crisis (without being too unkind to Deutsche Bank, David Enrich’s ‘Dark Towers’ is worth a look).

What the jumpy oil price and Metallgesellschaft have in common is an instruction on how the real economy and finance have become increasingly intertwined.

From an economic and investment point of view, there is plenty to consider in this regard. I am tempted to say that there is one sector that does not rely on finance – technology – but the corornavirus crisis has turned tech from an industrial gargantuan into a stock market monster (Microsoft, Apple, Amazon, Alphabet and Facebook account for 22% of the market capitalisation of the S&P 500 index). Next week’s tech earnings results may bring a reality check for stocks, and see volatility pick up.

The two other sectors to consider are banks and private equity. In the light of the Metallgesellschaft discussion what is remarkable so far in the coronavirus economic crisis, is that no bank has keeled over (I may speak too soon).

Indeed, the balance sheet restrictions that have been put in place, and general focus on risk management, appear to have paid off. In many countries, banks are now part of the rescue mechanism, and there is an opportunity for many of them to repair their reputations. In Europe the price of heavy regulation has, made banks very cheap from a valuation point of view so that there may be some upside if a round of consolidation takes hold into 2021.

Unlike banks, private equity has for some reason not come under the intense scrutiny of regulators, even as private equity (and private debt) have replaced the role of banks in parts of the global economy (i.e. shadow banks).

A crunch is coming however. In the USA, private equity companies are heavily invested in medium sized enterprises, and in any cases have taken on large amounts of debt to do so. As the economic toll of the coronavirus deepens, the financial pressure on private equity will translate into economic pressure on companies (leading to cost cuts and layoffs), and social pressure on their workforces. Sadly, this may have a deeper human, economic and political effect than the drama of negative oil prices and deserves to be watched closely by policy makers as the summer approaches.

Have a great week ahead,

Mike

Roof

Courthouses are fascinating places, and often help to shine a light on the deeper, darker layers of society. One example which sticks in my mind is the hosting some years ago by the London High Court of disputes between Russian oligarchs. The proceedings provided insights into the workings of Russian ‘capitalism’ and in particular uncovered the term ‘krysha’, or ‘roof’. Its essence is that individuals are given protection (roof) or cover from interference, in return for money or other obligations.

Whilst I know little about the darker corners of the Russian economy the phrase ‘roof’ struck me as a useful one in the light of recent central bank interventions. Regular readers of this note and those who have read The Levelling will know that I consider that in recent years central banks have encroached too far into financial markets, to the extent that they ‘own’ them, economically and psychologically. Amongst the many risks that this can lead to, is for investors to believe that risks in markets are uneven (i.e. the Fed will cover downside risks) and this may help to explain why it took markets so long to react to the outbreak of the coronavirus crisis in January.

The latest moves by the Federal Reserve, in particular that to support the high yield bond market, are redolent of ‘roof’, though ‘floor’ might be a better term. In doing so the Fed distorts market prices, offers one sided ‘bets’ to speculators and helps out reckless investors. Apart from curbing market disorder, some of the Fed’s actions will have very limited economic impact at a time when small businesses and many households in the US are struggling.

For some, this will create the impression that the Fed is beholden to Washington and more Wall Street than it is responsive to the broader American economy. What is more troubling is that the Fed’s activism will allow a stock market centric president (see my January 19 note ‘Peak Stocks, Peak Trump’) to claim a sense of ‘mission accomplished’, whilst ignoring the deeper economic and public health carnage of the crisis.

In markets, what is noticeable is that assets that do not have ‘roof’ appear to be underperforming those that do. Emerging market debt and fx have been weak, as have energy prices and copper, whilst small cap American stocks (Main Street) have underperformed the Nasdaq (Wall Street).

In this climate, the non-protected (non-roof) assets, or rather those that are not under the spell of big central banks, will likely continue to offer the best steer as to where the global economy is going – in that respect these assets (copper, oil and EM currencies) point to ongoing stress in the global economy. If this continues to be the case it will create a two-tier investment world where investors trade baskets of ‘roof’ (Fed sensitive assets) and ‘non-roof’ assets (economy sensitive assets) against each other.

In Europe, the propensity of the ECB to offer ‘roof’ is constrained by the political-economic divide between northern and southern economies. While the ECB has nonetheless been relatively speedy and generous in its actions, there has been something of a market backlash against periphery bonds (Italy in particular, and also Spain and Portugal). To one end, this strikes me as investors indulging in a habitual trade in that they expect every market crisis to become a euro-zone crisis.

One interesting rebuttal to this is that the US is beginning to look more like Europe. Note that US state governors (like EU state prime ministers) are enjoying a level of prominence they have rarely had and are beginning to form inter-state ‘pacts’ in the same way that countries within the EU are forming coalitions (i.e. France/Germany, the Hanseatic League 2.0). Financially, there will be greater market focus on municipal debt, the variability of real estate prices and mortgage debt across the US (a la Europe). So, Eurosceptics might well look to the US for their next trade.

As a final point Europe to reiterate the sense of recent comments of the French President, needs to give itself ‘roof’. Endless squabbling about debt mutualization is not the way forward here. The best approach is bottom up harmonization of processes – such as setting up a business, corporate governance and capital markets, not to mention harmonization of ‘emergency’ protocols for crises like the coronavirus crisis.

A more profound solution is to do what Europe has not done in a sincere way since its foundation – a strategy to grow its economies together, that goes beyond wordy plans and empty unenforceable commitments. That is the great challenge for Emmanuel Macron and those (myself included) who want the EU to thrive in a post coronavirus world.

Have a great week ahead,

Mike

League of Nations

Soon as competitive as the Champions League?

If the defining characteristic of the coronavirus crisis is its speed, then equally, one of its defining effects has been to expose the vast disparity in in the way countries have been affected by and dealt with the virus.

Though it is very difficult to have a true sense of numbers of infected as well as deceased, there are remarkable differences in fatality rates (per capita) if we say compare close neighbours – Ireland to England, Germany to France or even Norway to Sweden.

Whilst there are also some stark inter-state differences across the USA (Kentucky v Tennessee for instance), countries are still the best lens by which to view the effects of the coronavirus because they capture differences in laws, customs, social cohesion, institutions, political leadership and so on.

On balance, countries with good levels of human development, institutions and where the state is competent, seem to be doing a good job of containing the crisis. They are aided in this by largely obedient and well informed citizens, though the Easter weekend will test how obedient those citizens are.

So far, the crisis (beyond China) has centred largely on what we regard as the developed world (Europe, the USA and many Asian countries like South Korea and Singapore), but it is now picking up in developing countries.

Amongst the big emerging economies (China apart), Turkey and to a lesser extent Brazil stand out in terms of the onset of new cases. By and large, the emerging world has appeared to be be spared the scale of tragedy that has struck Spain and Italy, partly because testing is done sparsely (India has done 121 tests per million people compared to 13,000 for South Korea), and partly because these countries are less intensely connected to China and other international hubs.

In the near term, there is a growing need to tend to sharply rising poverty in the developing world, and a need to ensure that they are also well served in terms of medical supplies and knowledge.

When the crisis is over, emerging economies will have much to think about in terms of the resilience of their currencies (i.e. Rand), structure of labour markets, the patterns of migration and most importantly, urbanization and the role of public health systems.

This is a time when the rise and fall of nations is being accelerated and offers countries with scope for structural growth (i.e. Bangladesh to Ethiopia) a chance to stop and rethink their paths forward. They might also rethink how they are served by the dominant world powers and by international public goods.

In a context where institutions like the World Bank and World Health Organisation are being drawn into the geo-political rivalry between the USA and China (for example, the US President has threatened to cut funding to the WHO) there is an opportunity for emerging nations to speak out and to claim the best parts of these institutions for the developing world.

One suggestion might be to move the headquarters of the World Bank to Africa, which is the one region of the world that continues to need the expertise of the Bank. Locating the experts and executives of the World Bank in Africa will arguably make them more responsive, and better informed of the economic challenges there.

Equally, the expertise of the World Health Organisation could be harnessed for a post-corona crisis wave of public health education across emerging countries and an embedding of the health lessons of the crisis into urban and economic development planning.

There is also a greater strategic consideration at play. The developing world is still condescended to by the dominant economies and in the style of Thomas Pakenham’s influential book ‘The Scramble for Africa’. For instance, the crippling debt burden associated with the One Belt, One Road project will become more clear in coming months (e.g. Sri Lanka).

Given the way in which the crisis has exposed supply chains, there is potential for emerging countries to take stock of their strategic assets – an ability to produce some pharmaceuticals and healthcare equipment cheaply, and in certain cases, they are critical producers of food.

In a word order where national identities and borders have been reinforced, emerging nations may look to strike a tougher bargain with wealthier ones in terms of their hold over agricultural commodities. If they do so, they can become part of the levelling out of geopolitical power in the post coronavirus world.

Have a great week ahead,

Mike

Sitting quietly

Blaise Pascal – for how long can he sit quietly?

At this stage in the coronavirus crisis, many of us consider ourselves experts on pandemics and biology. The speed of the coronavirus through our world is paced by the speed at which our concern and curiosity is fuelling a quest for information.

One thread that has become evident to me, is that historically epidemics have not always been greeted with calm and grace. In periods when medical knowledge was not as well developed as it is now, and when democracy and public health education were fledgling, epidemics were often met with violence and disorder.

For example, in the early 1830’s cholera spread across Europe but efforts to contain it in countries as diverse as Scotland, Prussia and Russia were greeted with public attacks on doctors, nurses, and quarantine officers. At times, anyone in a white coat was a target. The general fear was that authorities were using the cholera epidemic to poison people so as to reduce the burden on the state or that doctors simply wanted cadavers for anatomy schools. We trust experts more today!

Compared to the nineteenth century, what is remarkable today is the degree to which populations – mostly in Asia and Europe so far – have followed the lockdown guidelines. In general, adherence to the lockdown has been highest in countries where trust in government (and perhaps fear in some cases) is greatest.

The next stage of the crisis, coming over the next two weeks, will severely test this trust. Whilst I am now tired of reading commentators quoting Blaise Pascal’s ‘All of humanity’s problems stem from man’s inability to sit quietly in a room alone’, millions of people across the world will face severe stress in terms of how they sustain themselves. This much was made clear by last Thursday’s initial jobless claims figure in the USA. At the height of the economic pain of the global financial crisis (March 27, 2009) the jobless number hit 665,000. Last week’s figure was ten times that.

With the number of coronavirus deaths per capita, per day, in the US now higher than during the US Civil War, the pressure on the US economy and its healthcare system will grow. The same will be true of many other countries, and though part-time or partial work schemes in economies like France and Germany may lessen the economic uncertainty, it will still weigh heavily. For instance, the past week has already seen food shortages in Italy, mile long queues for food banks in Pennsylvania. In many cases, loans, compensation and government payouts in the US will not arrive in bank accounts for weeks.

As this urgent, difficult stage of the coronavirus crisis develops, obligations on governments will grow. In Europe, there is an opportunity for what we might stereotypically call the ‘Northern’ countries to repair the diplomatic damage to the idea of EU solidarity of recent weeks (I am thinking of the Dutch in particular!) and undertake to ensure that food and basic staples can reach parts of the EU where they are needed.

In the USA, the past three years have seen a hollowing out of expertise in government. Consider that in 2017 and 2019 the Pentagon and White House economists respectively developed studies to plan for a coronavirus like pandemic, but the executive did very little to prepare for such an eventuality. In the longer-run, the state of healthcare and the fragility of the US labour market should become major political issues. In the meantime, I expect that both corporate America and the military will play a greater logistical role in meeting the needs of this next phase of the crisis in the US.

As this occurs, the debate on the marginal usefulness of the lockdown (in terms of its contribution to lives saved versus its economic impact) will grow. It has already been marked by what I call the ‘cure is worse than the problem itself’ brigade.

Two more weeks of lockdown in Europe will test the sanity of its citizens (though will I hope also show the value of this strategy) and business people. At very least, political leaders will have to outline some kind of roadmap to normalisation – the continued isolation of vulnerable members of society, wearing of masks, a gradual return to normal working patterns for example. Balancing this will be incredibly hard to do, and control. At this point, market volatility may give way to a pick-up in social and political volatility.

Have a great week ahead,

Mike