Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
Analyzing the Apocalypse
This has been a week for the ages. Or the aging. A decade or so of pent up risks unwound within the course of this week. One of my colleagues was quoted as saying “I just lost my last brown hair.” The other remarked how thankful she is to have a very good colorist. As long-term investors, we do not allow ourselves to be swept away in the emotions of volatile markets. That said, and although we have in our careers have seen numerous panics, what we witnessed was historic and unprecedented.
On Thursday, the Fed injected $1 trillion in repo liquidity, which sparked a rally on that day that lasted for only about 10 minutes. That is unquestionably a disturbing signal. It indicates that there is significant instability and distress in the financial system. We believe that there are hedge fund strategies and funds experiencing problems. We consider risk parity and other quantitative strategies that require correlations between asset classes to remain stable to be significant culprits. You can read more about that here: https://www.bloomberg.com/news/articles/2020-03-12/the-bull-market-meltdown-is-now-hitting-its-quant-poster-child. Effectively, the COVID crisis has turned into far more than a health crisis. It has become a crisis of confidence in leadership and health systems, and has evolved into one of credit. We saw a great deal of evidence that liquidity was impaired. For a more in-depth discussion on the credit markets, I highly suggest checking out our colleague Doug Noland’s latest commentary here: http://creditbubblebulletin.blogspot.com/.
The complete collapse of the OPEC+ paradigm sent oil prices reeling, and along with them a broad selloff of energy debt and credit alike. Globally, the industry faces the double black swan of demand contraction from COVID-19 at the same time it tries to absorb a supply shock. The Saudi and broader OPEC+ market share grab will be painful for domestic energy companies that have stretched balance sheets, of which there are many. There is almost $400 billion of investment grade energy credit on the verge of downgrade, as you can see from this graphic.
US activity in the energy patch will unquestionably grind to a halt as the entire industry is forced to quickly adjust to new realities. There are many companies that have benefited from, and even been propped up by, easy money and credit. The fact that these sources have completely dried up is a very unfortunate but ultimately necessary reckoning and rationalization of the domestic energy industry. The US energy industry benefited tremendously from OPEC discipline over the last five years, but the situation was untenable. The overproduction problem will begin to fix itself. Rigs are already being dropped, and several companies have announced aggressive cuts to their budgets. With this demand shock, a 3.5mm barrel a day cut (or more) would have been necessary to balance the market. Ultimately, however, all OPEC+ members need higher prices to meet their respective fiscal budget targets, and this may force everyone to come back to the table.
Even safe haven gold was a source of funds, as it was clear that there was a massive scramble for liquidity anywhere it could be found. With zero interest rate policy that shows no signs of abating, we believe this will ultimately be very good news for the gold price. However, at least in the short-run, we are respective of the downside and the need for liquidity in any asset class where it can be found.
The situation is very fluid. We are very respectful of the environment, and have maintained a great deal of dry powder. However, we also see some signs of capitulation. As risks recede and the headlines become incrementally more positive, which they eventually will, investors will come to realize that they are earning approximately zero on their cash balances and wonder about how they can generate portfolio income to meet their needs. There are many high-quality companies in our universe with very good balance sheets that have the financial strength to weather a recession. This is an excellent place to have our lists ready, in our view.
Chief Executive Officer