This commentary was written by Joseph Y. Calhoun, III of Alhambra Investments.
As I sit here Monday evening with the Dow having closed down 2000 points and the 10-year Treasury yield around 0.5%, the title of this update seems utterly ridiculous.
With the new coronavirus still spreading and a collapse in oil prices threatening the entire shale oil industry, recession is now the expected outcome. Most observers seem to question only the potential length and depth of the coming downturn.
The case of recession does seem to be one of those open and shut, slam dunk versions we don’t get very often in markets. The economic data has certainly deteriorated over the last year – although that was true before the arrival of the virus. In some respects, more recent economic data had actually improved somewhat. But with the actions being taken to combat the spread of the virus – work from home, no travel, etc. – future economic activity is now expected to slow further.
At the same time, the shale oil industry is facing an existential threat in the form of much lower oil prices. Last week OPEC – Saudi Arabia – and Russia failed to complete a production agreement to support the price of oil. The Russians apparently see this as an opportune time to attack the US shale industry and refused to cut production. The Saudis upped the ante and offered up oil at steep discounts to its customers over the weekend. The price fell 25% today to the low $30s. There are very limited, if any, shale areas where $31 oil is profitable.
The shale industry was already starting to struggle again with crude prices below break-even for most of the industry outside the Permian Basin. The industry went through a pretty good housecleaning when crude prices fell from over $100 in 2014 to the $30s in early 2016. There were a number of bankruptcies, stronger companies buying up assets on the – supposedly – cheap. Credit was cut off for a while during that 2015/16 rout but credit spreads eventually tightened again and drilling activity resumed.
Now, with oil back in the $30s, credit spreads are widening once again. Most of the industry is not profitable at these prices so new credit lines may be a moot point until prices recover sufficiently to justify drilling new wells. I don’t know what price that will be for the lenders but I’d guess somewhere north of $50. The fear in credit markets today is that at current prices, some of these companies will not be able to meet their existing obligations. Companies will continue to pump oil from existing wells but without new wells coming on line, production will eventually fall. Spreads today are still below the 2016 peak but are widening fast.
If shale production and drilling activity is curtailed in the coming months, which seems likely, it will impact economic output in the affected areas. By itself, it probably wouldn’t be sufficient to cause a recession – we didn’t have one as a result of the 2015/16 squeeze – but prices could fall further and stay down longer than last time.
Together, the coronavirus and the oil shock seem sufficient to push the US economy into recession.
The shale industry has become an important – maybe too important – part of our economy in recent years but it was always very fragile, dependent on continued high oil prices. Considering the cost to the rest of the economy from high oil prices I have wondered for years whether the geopolitical payoff was worth the price. I don’t think so but I am not in the consensus.
As I said, it seems obvious that a slowdown in shale production will be negative for the economy and I think that is probably right in the short term. But there are a lot more moving parts here than first meets the eye. Yes, the shale states are going to take a hit but the rest of the country will benefit from lower oil prices. And yes, oil prices are low but natural gas was one of the few assets other than bonds that managed to post a gain Monday. If shale shuts down will that cure the glut of natural gas? Someone seems to think so. Could all the negatives and positives just cancel each other out?
As for the virus, while we can all agree it’s a negative for the economy, the degree matters. Our goal from a tactical standpoint is to only make a change to our strategic bond allocation if we believe recession to be imminent. History says recessions are the most likely (but not only) trigger for large stock market losses but you can’t react to every slowdown. Every tactical adjustment requires two correct decisions – sell and buy. The more times you make a change the more likely you are to get only half that equation right.
I cannot predict how or to what extent the virus will spread and so I cannot predict the magnitude of any economic slowing associated with it. It seems likely, because we haven’t been testing in large numbers, that the reported cases will rise and we may start to get an idea of how big a problem we have. A rapid rise in reported cases could prompt more severe interruptions to economic activity than have already occurred. If that is what happens, a recession will be very hard to avoid.
Right now, I do not have sufficient information to confidently say we’ve hit a tipping point where recession is inevitable. The damage to the economy is still, mostly, at this point speculative. There are specific companies and industries that have already been negatively affected (cruise lines, hotels, airlines) but the degree of damage is still unknown. For those companies and the economy as a whole, this really seems to come down to time. How long will the virus impact activity? If it is short (4 to 6 weeks) we may still avoid a large contraction. If it is longer, recession is likely.
It is important to remember that even if this is a recession and/or bear market, there will almost certainly be more opportunities to sell stocks at higher prices than prevail in today’s jumpy markets. That often happens at the onset of recession.
Stocks generally react quickly – and often wrongly – to any perceived risk to economic growth. But even recessions caused by sudden shocks rarely move that quickly.
As events unfold stocks react to the latest data or policy announcement. Hope springs eternal, especially in the stock market.
At the beginning of the last recession, the first selloff was in the summer of 2007 and totaled about 15%. The Fed cut rates aggressively and the market rallied to a new high in October right before the start of the recession in December. The second drop was from that October high to a March bottom 19.5% lower. Stocks recovered nearly 2/3 of that loss before hitting the skids again. Stocks managed a 15% gain after the onset of recession on (misplaced) optimism about the Bear Stearns deal. By that time our recession indicators were clear with the yield curve, credit spreads and the CFNAI all in agreement.
The point is that history says we can wait for more evidence before taking any drastic actions. Even if we are already in recession stocks can still offer surprising rallies. Some of the biggest up days and weeks in the history of the market have come during bear markets. This one, if that’s what this is, will likely be no different.
Our accounts are holding a decent amount of cash, raised over the last two months due to changes in momentum, and if we get sufficient evidence to call a recession, we will do more selling. My goal is for that selling to occur within about 10% of the ultimate high. I can’t say for sure that will happen obviously but based on history it seems a reasonable expectation.
I am not overly sanguine about the global economy; there are a lot of negative headlines right now. But over my long career, I have also come to realize that economies are not that fragile; they take most obstacles in stride. Don’t underestimate the ingenuity of humans and the power of their desire to improve their condition.
Recession? Maybe, but not yet.
This is a Hedgeye Guest Contributor piece written by Joseph Y. Calhoun, III of Alhambra Investments. Joe has worked in the financial services industry since 1992 in various capacities, including Operations Manager, Compliance Manager, Registered Representative and Portfolio Manager. He is the CEO of Alhambra Investments.