Lewis Johnson writes “Inflation scares this deep into one of the longest cycles in post-war history should be viewed with skepticism, in our view, because of the shaky foundation upon which they are built. Just a few days ago, many feared how the economy would cope with the inflationary pressures from crude oil prices which seemed inexorable in their climb toward a hundred dollars a barrel. Now, it appears investors are again fearfully updating their models, only this time to the downside. Transitory inflationary fears are being replaced with the sober realization: weaker crude oil prices could weigh upon many parts of the economy. Think about it.
The U.S. is now the world’s largest producer of crude oil. Trillions of dollars, much of it borrowed in the junk bond market, went into financing this production increase. In fact, nearly 20% of the junk bonds sold in the past decade have gone to financing this production boom and its associated infrastructure. How much of U.S. industrial production is dependent upon a strong crude oil market? If crude oil prices remain depressed, will weaker debtors be able to honor their commitments? What about the health of the banks who lent them money? What about employment? The questions are starting to mount.
It’s Better to Be Long the Solution Than Short the Problem
In a way, we believe that we can achieve a similar outcome in the financial markets when seeking to hedge out the risks of owning an equity portfolio into the peak of the cycle. Like so many of the world’s elegant solutions, it hides in plain sight, protected only by the controversy that surrounds it. We think that longer dated U.S. government bonds can act as such a hedge, which is why they play an important role for us when we seek to create a more defensive portfolio. ( disclosure… I am heavily long US treasury through leveraged ETF)
You need look no further than the buoyant performance of such bonds during the 2008 and 2011 equity bear markets, when they returned nearly 40% while equities fell.
In Conclusion
The hardest task in portfolio management, in my opinion, is managing a portfolio into the peak of a cycle. Look no further than the squeeze up and crash in the crude oil market. Cycles are volatile.
Our solution, learned through hundreds of cycles, is to manage risk proactively. It’s times such as this that the discipline of valuation and proactive risk management can add the most value to portfolios. We believe that the “cost” of such strategies – selling early and favoring quality to avoid the worst ravages of downcycles – is worth the “risk” of potential near-term underperformance. ( I agree)
One pertinent fact not mentioned, the cost of producing crude has fallen by more than half from what it was in 2013-4. So even at $50, reports suggest Permian crude can make great profits.
The article goes on to create the awareness of low crude prices, but does not put an estimated figure. That is a scary act. Yet, Asia is consuming crude like never before and so long term it shall only go higher.