Ben Obi-Wan Kenobi: "You can't win, Darth. If you strike me down, I shall become more powerful than you can imagine."
Han Solo: "Kid, I've flown from one side of this galaxy to the other, and I've seen a lot of strange stuff, but I've never seen anything to make me believe that there's one all-powerful Force controlling everything. 'Cause no mystical energy field controls my destiny. It's all a lot of simple tricks and nonsense."
Princess Leia Organa: "Your friend is quite the mercenary. I wonder if he really cares about anything. Or anybody."
Yoda: "Do or do not. There is no try."
Han Solo was foolish to doubt the force. In a galaxy far, far away - where Han Solo and his fellow rebels lived - the force was strong enough to lift an X-wing fighter from the muck of the Dagobah swamps and guide a kill shot to the heart of the Death Star. There is only "Do or do not," as Master Yoda put it, and with the force Luke "did." The force for Luke was real.
In the world of trading there is no "force"… or is there? As the great value investor Marty Whitman once put it, "Rarely do more than three or four variables really count. Everything else is noise." Whitman was talking about individual stocks, but in macro the same idea applies. There are only three or four MAJOR variables truly shaping markets at any one time, and if you are in synch with those variables "the force is with you." If you are fighting them… good luck with that.
Fighting the force is generally a dumb idea and sometimes it gets you killed. Take, for example, the "too clever by half" value investors and hedge fund managers who decided to buy oil and energy stocks halfway through the now historic decline, on premature assumption the downside move was "overdone." There is an art to respecting the force and many market participants are oblivious to it, particularly in times of budding crisis.
This is why one of our favorite observations from Jeremy Grantham holds true: In a real crisis, lazy value investors do better than diligent ones. The diligent value investor is falsely roused to action by valuations that are cheap, while the lazy value investor does not heed call to action until crisis valuations are insanely cheap. Then too there is the nature of paradigm change. "Buying the dip" or "playing for a rebound" are actions that apply within the old paradigm. When there is a major sea change and the paradigm shifts, that same "buy the dip" playbook is suicidal, especially when applied by smug market participants who lack risk control. We caught the downdraft in energy stocks this year not because we are super-smart, but because a weakening crude oil market tipped us off, and we were paying enough attention to take act. The force whispered in our ear…
The force is now with energy and credit bears as the House of Saud rains down destruction upon its mortal crude oil production enemies. The blatant attempt to kill off US shale producers is causing havoc and collateral damage all over the globe. Consider the following facts:
• OPEC members consistently cheat on their quotas.
• OPEC controls a mere 30% of the world's oil supply.
• Saudi "swing producer" status is mortally threatened.
• Saudi Arabia has a roughly $900 billion war chest.
• Saudi production costs run as low as $5 to $6 a barrel.
Imagine you are Saudi Arabia. Crude oil is your life's blood. It is your entire world - your past, present and future. If you permanently lose control of the oil price, disaster awaits your future generations. You look around and see new production threatening your "swing producer" dominance. Even worse, you see the advancement of new technologies, like electric cars and natural gas fuel conversions, that mean long-term declines in Western World crude oil use (with downtrending statistics for oil usage to GDP growth already starting to kick in). Worse still, you see global demand now sagging in absolute terms, threatening to stall out. The oil price is moribund. Your fellow OPEC members turn to you, the big dog of the bunch, begging you to cut production and keep prices up. But why in the world would you do that? Production cuts would send precious cash flow to your mortal enemies. Dollars from a propped-up price would flow to their pockets too… and hasten your ultimate demise.
So instead, for the sake of future generations, you (Saudi Arabia) must wage a war. A crude oil holy war. You have done this before - in the mid-1980s - and you know what to do once again. You must open the taps, and let the crude price fall and fall, to levels not thought possible, until weaker production at the margins is shut down, bled out and destroyed. If you can kill off these marginal crude producers, and terrify global investors into largely swearing off energy finance projects for another decade or two, your future as an oil power, and a proud nation, will be far better secured. This is a fight to the death for the sake of tomorrow. You have $900 billion in reserves and production costs as low as five bucks a barrel. You will bury those who challenge you.
"We [the members of OPEC] are not going to change our minds because the prices went to $60 or $40. We are not targeting a price; the market will stabilize itself."
~ Suhail Al-Mazrouei, UAE energy minister
Not "targeting a price," but blood. It takes time for the pain of rock-bottom energy prices to ripple through the system in the form of credit blow-ups, project cancellations, capex reductions and shutdowns. OPEC will wait for this result…
In the eyes of the House of Saud, US shale producers are the true mortal offenders. They alone are the ultimate threat. If the Saudis could thus target US shale producers and no one else, they probably would. But that is not how it works. The price of crude is global, thus price war fallout is global. As a result, for all the havoc US shale producers will face, others are being hit much, much harder by oil's collapse. Consider the following chart showing average production costs for various crude oil producers (via the Financial Times):
Canada's oil sands top the casualty list. After the United States, Mexico and Brazil are next in line. Beyond that many non-OPEC producers, and even Norway, are facing a world of pain. For Canada in particular, we salivate at the thought of the coming housing bust. We have already made a great deal of profit this year being heavily short the "commodity currencies" (Aussie and Canadian dollars). The best may be yet to come, however, as the stubborn housing bubbles in both countries are drawn ever closer to a full-on bust.
Projects are being shut down left and right in Canada. Thousands of oil workers are being laid off as global energy corporations (many of them US-based) pull their oil-sands related projects, or alternatively cut capital expenditures way back. And why should it be any different? OPEC has shown the desire and the willingness to take Canadian crude below fifty bucks and let it stay there. On a trajectory of just a year or two at that level, oil sands projects are toast. We are likely going to see a major, major housing bust up north, just as Australia will experience delayed pain of similar type as base metal prices fall fifty percent or more.
Nor do the "commodity countries" have the worst of it. At least these are wealthy nations, where a housing bust will hurt but not lead to rioting in the streets. In comparison take poor old Venezuela, where the interest rate on the two-year note recently hit (wait for it) an eye-popping sixty percent. The odds of Venezuelan debt default are basically a lock. The country relies on oil for more than 95% of export revenues and owes as much in near-term debt obligations (24 months or less) as it holds in foreign reserves (last count $21 billion). The force is not with Venezuela we're afraid…
An unpleasant reminder for gold bugs, via Natixis and Sober Look: Of the paltry reserves Venezuela has left, roughly 70% are held in gold. The country is now in such dire straits, they were recently caught negotiating with Goldman Sachs. You think they'd be above selling a little gold? Russia, another noted hoarder of gold, was recently caught selling gold too… Vesti Finance, a Russian news source, recently reported a $4.3 billion decline in central bank gold holdings. The force is most definitely not with gold bugs, as those countries who champion themselves as enemies of the United States, and lovers of gold, are now on the fiscal ropes via collapsing oil prices. When you further look around and see collapsing inflation expectations, a rapidly strengthening US dollar, and the US Federal Reserve on a hawkish trajectory, the argument for buying gold here is all but nonsensical. We are not permabears on gold, or "perma" stance on anything for that matter… but here and now the yellow metal looks as awful as we've ever seen it. A large Russian or Venezuelan sale, hitting the gold market with a thud, would be a gray swan of sizable proportions that hits the optimist crowd like a falling anvil. And just to add insult to injury, funds deployed for a gold sale might be switched into US Treasuries at that!
Speaking of which, the force is definitely with US Treasuries (NYSEARCA:TLT)… and, at least for the moment, with Mercenary Trader. We wrote about the potential for a massive UST "pain trade" in SIR 58 (appropriately titled "Exploring the Pain Trade"). As such, we caught the longside breakout in IEF (the 10-year note)… then closed the position at breakeven on a fallback relating to strong US economic data… and then re-entered a sizable long bond position, via short Ultrashort Lehman 20+ Treasury ETF (NYSEARCA:TBT), on Dec 8th. This one may stick, adding to our roster of "big trades" for 2014: Long USD across multiple pairs… short energy stocks… and now bullish long bonds, if the vertical breakout thrust holds…
To know why long bonds are rising, consider why emerging market equities are falling. (This is another trade we caught in size, via shorting Emerging Market Bull 3X (NYSEARCA:EDC) on December 1st: If you would like to see all our real-money trade setups broadcast in real time, and sent to your inbox with commentary prior to market open, check out the Live Feed)
First, the Saudi "oil war" may have very nasty geopolitical blowback effects. As we have already noted, Venezuela is practically a lock for default. In addition to Canada, oil producing E.M. nations (like Brazil and Mexico) now find their finances under siege. Meanwhile Russia, Putin is being backed into a corner (and is capable of anything, as we explained in SIR #46, "The Dogs of War"). This factor alone makes emerging markets an unappealing place to be… and in turn enhances the attraction of safe haven long bonds.
Second, structurally cheaper oil prices mean even cheaper commodity prices - bad for emerging markets, too. In our bearish write-up of Rio Tinto (NYSE:RIO) - SIR #53, we noted the nasty tendency of big producers to keep production up even as prices fell, in an effort to maintain or expand market share. As the oil price falls, commodity production in general gets cheaper… which underscores the logic of price wars across the space… which further hits EM producers.
Third, China is in deep trouble. Plummeting crude oil prices are not just about supply-side oil wars and a rising dollar (though these are certainly factors). Crude's vertical drop also reflects increasing pessimism as to global demand… and in particular China's future prospects. We have Asia-based readers determined to take an optimistic view on China, and we respect all intelligent and thoughtful opinions. With that said, the force is not with China at moment either… and the numbers are starting to get frightening. We more or less agree with Ann Stevenson-Yang, a long-time China watcher (and China resident) who said this in Barrons:
"…most likely, China is sinking into a deflationary recession that's increasing in speed and may take some time to run its course. Investors have lost faith in the property market… Employment and wage compensation will suffer. Consumption will continue to suffer. There's even an outside possibility that China's economic miracle could end up in a fiery crash landing if a surge in banking-system loan defaults outruns government regulators' attempt to contain [it]…"
Note the extreme divergence above, via Thompson Reuters and the FT. Thanks to oil prices falling like a stone (and gas prices at the pump hitting lows not seen in years), USA consumer sentiment is hitting multi-year highs… even as China industrial production is falling off a cliff. The United States economy is well and truly "decoupling" from ROW ("rest of world"). This in turn makes ROW pain worse in respect to credit tightening impacts. Because the United States represents 25% of global GDP and runs the world's monetary reserve currency, which is responsible for more than 80% of world trade, US monetary policy is more important than any other country's by orders of magnitude. At the same time, the USD "carry trade" is multiple trillions in size, which means borrower pain when the dollar rises. As such, when the USD rises in concert with a hawkish Fed and US economic strength, the impact is a de facto credit tightening for ROW (the rest of the world). This is coming at the worst possible time for battered emerging markets, not to mention deflation-prone China and Europe.
Note, too, that the rising 2-year Treasury yield is a better forecast tool for Fed rate hikes than falling long bond yields. The Federal Reserve is still on a hiking path, in spite of pronounced global weakness. Long bonds are strong (and long yields falling) because ROW is so weak and sovereign yields are converging. US economy strength adds tightening bias, increasing 2015 crisis potential via ROW gray swan risk.
The above is an excerpt from the December 15th Strategic Intelligence Report.
Disclosure: The author is short TBT, EDC. Also long the US dollar vs. a basket of currencies.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.