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The Sound of One Hand Clapping


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First, let’s deal with the elephant in the room. I predicted global risk destruction with the failure of the crude oil production freeze meeting last week. Instead, we got relatively stronger equity markets, tighter investment grade corporates (despite another week of heavy issuance), tighter high-yield spreads, and better emerging markets. Moreover, commodities, as measured by the Thomson Reuters Core Commodity Index (CRB), increased 3.6%, with WTI Crude Oil front contract (CLM6) up nearly 4%. Treasury yields, that I thought would fall, rose, quite a bit.

Why did we get such a counterintuitive (in my mind) response to the failure at Doha? It has taken me many years and lots of bumps and bruises to “figure this out.” Sometimes, markets just do what they are going to do. There’s nothing scientific, there’s no conspiracy, there’s just the momentum and psychology of the market that has the power of a river. It goes where it wants to go. After the weekend of failure for OPEC and Russia to come to an agreement, folks woke up Monday expecting the world to end and when it didn’t, they went back to doing what they have been doing since mid-February, deploying capital to risk assets.

The thought process that is driving the markets right now is that commodities and China have stabilized, the major central banks of the world are providing massive amounts of liquidity, and global final demand growth is on the horizon. The growth may not be huge, but it is enough. When an asset manager is tasked with deploying capital, especially managers with relatively little flexibility between asset classes, if the world isn’t ending and your market is continuing to march higher, most managers will fall into line. Meanwhile, investors who have fought the trend and have gotten badly beaten up the last two months have stopped resisting, especially after crude didn’t crash post-Doha, but actually increased.

So, with that being said and giving all due respect to “Mr. Market,” there is one important word that rarely gets mentioned in conversations around commodity prices and central bank liquidity and lending programs. That word is demand. It takes two hands to clap, and right now, all we hear about is supply, whether it be crude oil, bank credit, or industrial commodities. When it comes to crude, all we are concerned with is supply. Did the supply glut grow? Are the Saudis going to pump more or less? Did rig counts fall again this week? Honestly, how many of us even knew what a rig count was, or where Cushing was a year ago? Now, ask yourself: how many reports do we wait rapaciously for every week, or even every month, that provides us details about demand for crude other than it continues to be way below supply? The answer is, “Not so much.”

The same is true for bank lending. Last night, Bloomberg News reported that The Bank of Japan (BOJ) is considering adopting negative interest rates for their existing Stimulating Bank Lending Facility. Like the European Central Banks TLTRO-II program, the facility could effectively pay banks to lend, or at least give them back some of the money the BOJ takes away from them with their Negative Interest Rate Policy (NIRP). Unfortunately, supply of lending capital isn’t the problem. From Bloomberg:

"In Japan, where the sub-zero rate became effective in February, a survey of senior loan officers showed this week that banks’ profit margins from lending to highly rated companies dropped to the lowest level in almost a decade. The BOJ’s quarterly survey also showed that demand for credit from large, medium, and small-sized firms all dropped."

The same phenomena is happening in Europe. Demand for credit is just not present, and without that demand in Europe or Asia, be it for credit, for commodities, or for finished goods, the global economy is trying to clap with one hand and that doesn’t work.

With this in mind, I continue to be wary of credit and commodity risk and I am in favor of buying Treasury duration—especially after this week’s back up—or duration off very high quality assets like municipals upon any significant widening, like the kind we saw this Thursday.

Member SIPC & FINRA. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor.

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