“Efficiency is doing better what is already being done.”
-Peter Drucker
While Peter Drucker has been referred to as the “founder of modern management,” Peter Thiel might say that running in circles trying to do better than what is “already being done” is at the top of the list of societal inefficiencies. In his book Zero to One, Thiel gives one simple rule to prospective entrepreneurs:
If you want to create and capture lasting value, don’t build an undifferentiated commodity business.
In reality, 1) we’re not all entrepreneurs, 2) Many of us exist in highly-competitive, commoditized businesses; and 3) a majority of us aren’t operating with a monopolistic shield (although this is arguably the goal).
To merge two varying ideologies of optimal advancement that scream generational mismatch, if you are in fact selling what many others are selling, hopefully you’re the leanest, most flexible operator. Accepting that the future is unpredictable and that prior plans will undoubtedly change is the first step to survival.
Over-investment at peak margins is an ever-occurring historical phenomenon. For recent examples take a look at iron ore or potash capacity additions circa 2004 through the financial crisis commodity-bubble highs:
- Cap-ex less D&A for the largest miners increased nearly 6x from 2004-2012 (see a chart of iron ore on how that story ends)
- Iron ore production increased nearly 170% from 2000-2012
- Potash production capacity has increased 60% since 2000 on double digit Y/Y cap-ex spend growth from the largest producers from 2004-2013. Until the “emerging market demand for better food” story actually manifests, we consider this a slow to no growth, elastic demand story. Canpotex monopoly cartel or not, margins are still high which pulls the cost curve lower with the potential for prices to follow.
Whatever your view on the reasons for a capital spending boom the implications are straightforward:
1) Over-Production
2) Lower price floor
Bottom line: people are just get better at producing commodities.
Back to the Global Macro Grind...
After a 2-step FX devaluation out of China this week and a parliamentary approval for a third Greek bailout package (shocker) ahead of Mario Draghi’s main event in Jackson Hole, the market is sniffing out what has been a de facto tightening from the relative central policy abroad.
We consider Beijing’s move on Tuesday and Wednesday a quasi-acknowledgement of economic reality which is warranted after an awful month of July data if you contextualize top-down macro on a rate-of-change basis:
- Industrial production missed estimates, printing +6.0% Y/Y in Jul. vs. +6.6% est. (+6.8% prior)
- Fixed asset investment hit a 15-year low
- Property investment growth slowed to +4.3% Y/Y which was the lowest reading since March 2009
- Factory output slowed Y/Y sequentially
- Exports declined -8.6% Y/Y vs. -1.5% est. (+2.8% in June) à Chinese crude steel output -4.6% Y/Y (-1.8% Y/Y through first 7-months of 2015)
The devaluation pushed bets on the probability of a September lift-off back below 50% and tagged the dollar -1.1% on Wednesday.
The ensuing reflation trade (XLE led sector performers at +1.8%) is the biggest risk to those positioned for deflation via commodities and related derivatives. Consensus remains positioned for deflation. We reiterate our view but remain cautious and weary of a snap-back reflation trade:
TTM Z-scores of non-commercial net-long futures and options positioning from the CFTC:
- USD (Consensus LONG) : 0.64X
- GOLD (Consensus SHORT): -1.88X
- EURO (Consensus LONG): 1.37X
- CRUDE OIL (Consensus SHORT): -1.17X
- 10-YEAR Treasuries (Consensus LONG): 1.5X
Reflation trade aside, central bankers remain in a box on the harsh reality that they can’t print growth, and the rotation to growth-slowing asset classes remains persistent with one of our top long sector ideas in utilities (XLU) leading S&P sectors month-to-date (+3.7%).
The set-up for the September meeting is as follows:
1) The Fed runs the risk of tightening into a late-cycle slowdown which could ultimately flatten the yield curve.
2) Slower growth and deflationary headwinds are acknowledged and the can is kicked on a rate hike which should also be good for bonds. Until growth inflects positively, you’ll see TLT in our investment conclusions.
The largest discrepancy in our Growth, Inflation, Policy model vs. consensus and central bank estimates is our full-year inflation forecast.
Full-year 2015 CPI Forecasts:
- Hedgeye Predictive Tracking Algorithm: +0.2%
- Bloomberg Consensus Forecasts: +0.3%
- Central Bank Forecasts: +1.4%
As is often the case, the Fed overshoots on its inflation forecasts. Their forecasts may have lost some credibility, but the point is that they’ll have to acknowledge overstated forecasts. Whether it comes at the September meeting or after Q3 data is released, we expect them to ultimately talk down the currency, and judging by consensus positioning, this is NOT consensus.
With growth slowing, an FX catalyst, and secular headwinds globally coming to fruition at the same time, our expectation is that we will continue to see who in commodity-leveraged industries is “swimming naked” as Warren Buffett likes to say. It’s only a matter of time before the carnage in the energy space flows through to the real economy (see Chart of the Day below).
The over-investment in commodity related industries from ~2004-2010 is unraveling. If you have to be invested 2H 2015 is probably the time to find the most conservative management teams and the lowest cost producers with the best asset base over rolling the bones on those riskier names most levered to a reflation trade.
One of the big surprises for those not in the weeds on a daily basis has been the resiliency in U.S. shale production. Hedging, long-term drilling contracts, etc. aside, the best producers have made rapid advancements from a cost-perspective. The forward curve reflects this psychological shift that was met by skepticism during the first leg down to the March lows.
“Our after-tax rate of return at $65 oil were better than at $95 oil three years ago. We are pleased to report that we have further improved these well economics, even as oil prices have declined. Through improved well productivity and lower cost, our key oil plays now earn a 30% after-tax rate of return with a flat $50 oil price.” - EOG Q2 2015 Conference Call
Unless you have a crystal ball, keep evolving and stay lean.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.14-2.25%
SPX 2072 - 2111
RUT 1196 - 1244
Nikkei 205
EUR/USD 1.08 – 1.12
Oil (WTI) 41.59 – 46.65
Good luck out there today,
Ben Ryan
Analyst
