Trend Management, Inc. First Quarter Report 2016
If you like stock markets that are volatile and chaotic this quarter was for you. Our accounts on average finished the quarter in positive territory. We are sure when you looked at your account in February you were probably thinking that was not going to happen. It is surprising we finished up after the Dow Jones had its worst January in history. The markets aren’t out of the woods yet. There is a lot going on in the world we need to talk about, including a few thoughts on the election coming up. Don’t worry, we won’t pick a candidate. However, what’s going on in the political world is going to affect our investments.
The majority of this report will be about macro investing and the big themes we see changing. If you are not into macroeconomics skip to the last page. Before we get into world economics, we want to mention that we did not see anything noteworthy in what our companies reported this quarter. Earnings were about as expected. We will talk more about them next quarter. We would like to note that after they released earnings, both Royal Gold and American Public went up 50%. The reports weren’t that great, it was just that sentiment was too negative. It seems crazy to say they reported in line with estimates and their stocks went up 50% afterward but that’s how this business is sometimes.
You have probably heard this phrase from central bankers in the last 15 years, “You can never spot a financial bubble until it pops”. They said that about the .com market in 2000 and the subprime real estate crisis in 2008. We disagree with that statement. The exact timing of an end to a bubble is impossible to predict but that you are in one is not. We think we were in an oil production bubble and it has ended. This oil bubble was financed by cheap money in the USA that is now going away. The ending of that bubble will matter to the world.
As you can see from the chart above, as the fed printed money to get the USA out of the Great Recession and one of the beneficiaries of that “free money” was the oil industry. Drilling for oil is not a great business. It needs lots of money to increase production which it usually doesn’t have access to. That all changed in 2011.
From 1986 until 2011 oil production in the US went from 9.6 million barrels produced per day to under 5 million barrels produced per day. From 2011 until the middle of 2015 oil production recouped all of that lost production. The increase in oil production on page 1 is not sustainable. The prevailing wisdom on why oil production has increased is new drilling techniques like fracking have made it easier to drill. That is part of the equation but not all of it. We would like to point out that fracking has been around for a while and started gaining in acceptance in 2005. From 2005 on these “new” drilling techniques didn’t move the U.S. oil production needle until 2011. Why?
A lot of the wells that are being “fracked” today are like cigar butts that are laying on the ground. There are one or two good puffs in them and then you throw them away. The marginal wells that were being fracked in this decade are like burning cigar butts. You get about 70% of your production in year one and then there are a few “puffs” left before you go to the next well. Because production declines so quickly in year two, these wells need cheap capital to succeed. When that capital showed up in 2010 the oil industry was off to the races and so was production.
As you can see from the chart above, the availability of cheap capital in this sector is over. We think over the balance of the next few years’ oil production in the U.S. is going to decline back to the 6 million barrels a day level or lower. Even if the price of oil goes back to 100 dollars a barrel we don’t see credit coming back to fuel oil production like it did from 2010 to 2015. When a credit bubble bursts it is usually a decade before the participants who lent money to that sector tip toe back in. If there is a decline in U.S. oil production what should we do? The answer may surprise you.
Robert Triffin was a famous economist from the last century. He was famous for what was called Triffin’s dilemma which we will paraphrase; “That whatever country is the reserve currency, it must be willing to supply liquidity to the world when it needs it, even when that liquidity is to the detriment of the reserve currency”. The U.S. is the world’s reserve currency today. The dilemma begins when the reserve currency needs to choose between what’s right for the reserve currency’s domestic policy (the United States) and what’s right for the world’s economic good. Many times those goals diverge. Hence the dilemma of what should you do? Protect “your” people or the worlds.
We bring this up because we have just lived Triffin’s dilemma the last few years though with a twist the markets haven’t figured out yet. There are two ways the United States can help the world get through Triffin’s dilemma of supplying liquidity. One is by printing money (liquidity) and the other is by running a trade deficit (demand). Printing money helps the stock markets of the world, running trade deficits helps the business of the world (to the detriment of U.S. business). When the U.S. federal reserve started printing money in 2008 it was one way to help the United States and the world’s financial assets. So far so good. The U.S. stock market rallied and world stock markets rallied. You can only print so much money to help the rich get richer in stocks and bonds before somebody has to buy a real asset. That is, we need more demand for actual orders of goods and services across the world. Higher stock and asset prices can only help demand “trickle” down for a while before it loses its effectiveness. Trade deficits supply demand to the world from the deficit country.
In the 2000’s the United States was a huge contributor to world DEMAND by running a massive trade deficit fueled by excess debt creation. Europe also ran a trade deficit along with China buying every commodity in sight. This was a perfect scenario for emerging market growth. Before 2008, the US was exporting over 450 billion dollars from oil alone to the rest of the world as part of its trade deficit. That money was consumed by the emerging markets which created growth for the world economy. As a frame of reference, the total GDP of Latin American countries was under four trillion dollars in 2008. Our oil deficit helped fuel the world’s economies tremendously. However, starting in 2012 our trade deficit in oil started to shrink. Because the world’s central banks were printing so much money (liquidity) nobody noticed. The decline in our oil deficit was caused by cheap money fueling oil production (higher oil production lowers our trade deficit). Last year the U.S. “only” sent out 100 billion dollars in “oil money” to the rest of the world from its trade deficit. Most of that decline was because of increased US oil production and a reduction in the price of oil.
To make matters worse, Europe actually ran a trade surplus not because of increased exports but because Germany has imposed austerity measures on Southern Europe. Europe has squashed the demand of their citizens to consume. China has struggled because both the U.S. and Europe have pulled back. Even though China has a massive trade surplus with the U.S. which should benefit their people, China over the last decade has decided to impose austerity measures on their citizens by lowering their consumption as a percent of GDP from 50% to 35%. This level of consumer consumption as a percent of GDP is unheard of in a developed economy. So in Triffin’s dilemma, when the world needed more demand for goods, each of the major countries chose to protect their own financial system. Printing money which is being tried in earnest by the ECB and Japan to generate demand is not enough to fix this problem.
We think the decline in commodity prices worldwide was caused by the U.S. running a very narrow trade deficit (as a percent of our GDP) while Germany imposed austerity measures on the Euro zone. What we are predicting now is that the narrowing of our U.S. trade deficit is over. The oil bubble masked what is a deteriorating trade position in the U.S. When oil production declines in this country the U.S. will again start sending 100’s of billions of “oil dollars” out to help the rest of the world. They will welcome that money with open arms. When that occurs their economies will kick back in gear and they will consume all of that money versus what the U.S. would consume. They will even borrow more money to consume than the U.S. would because they have less debt to GDP than we do. The emerging markets we are looking at are all down over 50% from their highs 5 years ago. If our trade deficit widens, they will benefit and we should buy them. Why haven’t we? What are we waiting on?
For over 30 years now the guiding force in world economics is what is called the Washington Consensus. We will sum it up by saying the guiding principles of this consensus are free trade, free markets, less taxes and less regulation. The Washington Consensus is guided by the thought that markets know best which we tend to agree with. However, there is no acknowledgement that people/countries cheat or “game” free markets. Economics 101 doesn’t know how to handle cheating so they ignore it. Countries are more than happy to game the system for their own benefit (China, Germany and Japan). It appears to us that the Washington consensus is going to stop and be replaced by something else. Why do we feel that way?
Bernie and Donald are why. When the far left and the far right get together and agree on something you should pay attention. Both Bernie and Donald are running on a very anti-trade, anti-free market rhetoric. They are both advocating an end to trade agreements that are deemed unfair. Each might solve it in a different way but they are now changing the debate on what’s wrong with the Washington consensus. The supporters of these two candidates on this subject know something is wrong and they are willing to bet it has to do with trade and free markets. This political debate is brought up at a time when we are NOW predicting that the U.S. is going to start running huge trade deficits again as our oil production declines. The world needs those deficits; we might need the worlds money to fund those deficits but our politicians may stop it. Is that a bad thing? Sort of.
As you can see from the US Trade Deficit with China chart there is something wrong in our trade with China. The trade deficit with China is at extreme levels. In the interest of brevity, we won’t look at Germany and Japan who have similar charts as the one above. The support for anti- party establishment candidates on both sides of the aisle are an indication the American people might think this is a problem as well. What will our leaders do about this?
We hear this phrase all of the time “Trade wars caused the Great Depression”. We don’t agree with that statement. If that was the case, then why did the trade war of 1971 not end in a depression? The U.S. under Richard Nixon imposed a 10% tariff (and price controls) on all goods coming into the U.S. on August 15th of 1971. After that date manufacturing hours and inflation in the U.S. actually picked up. Bank loans accelerated as U.S. production of goods replaced imported goods. There was no depression.
What we think has caused the slowdown in worldwide growth, is a huge imbalance in trade of which the U.S. has been on the wrong side. The U.S. has over consumed but Germany, Japan and China have under consumed. In a perfect world where everyone plays by the rules, trade should balance evenly. We are for balanced trade, where money doesn’t pile up on one side of the Atlantic or Pacific Ocean to the detriment of the other side. If one country practices free trade and the others do not, you get the worldwide mess we are in now.
To make sure everything balances out, the currencies of the surplus countries should go up and THE CONSUMPTION of their citizens should go up. If the U.S. trade deficit widens too much, its currency should go down. This decline will decrease consumption and narrow the trade deficit. If China consumes too little, its currency will rise which will increase the consumption of its citizens. The Chinese government (and other surplus countries) should also encourage through public policy more spending on its citizens. That’s the way its suppose to work.
We are convinced that if the current system continues without intervention from our politicians, the U.S. will run larger trade deficits than it did in the last decade. Even if oil production stays flat from here which we don’t expect, the trade deficit is going to widen. Based on this view we intend to invest in emerging markets for the first time. We believe thatour current positions in Exxon, Royal Dutch, Nucor, IBM and Royal Gold are beneficiaries of a declining dollar. We don’t think that the anti-trade movement can change our trade agreements quickly. Theoretically it is the role of Congress to approve trade deals. That said, Richard Nixon quickly imposed trade tariffs in 1971, so it can happen. We don’t think a trade war will hurt Latin America compared to what it will do to those surplus countries we mentioned above.
We will summarize this report to make it easier for you to follow going forward.
Oil production was in a bubble caused by cheap money. The oil bubble has ended.
The oil boom temporarily caused the U.S. trade deficit to narrow which helped our currency go up but hurt world growth.
The end of the oil boom will cause the U.S. trade deficit to widen and the dollar to decline.
World growth will return as the U.S. “exports” more money to the world.
Some form of protectionism is likely to occur led by the U.S.
Inflation will return to the U.S. as the dollar declines.
Wages in the U.S. will rise benefiting the middle class.
Owning emerging markets who export commodities will be better than owning U.S. markets
Central banks will be less important as fiscal policy and trade policies take over their role.
At some point this year we will be buying emerging markets. We will have a position of around 10% in this area.
As always feel free to call us with any questions you have on this report.
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR