OPEC is in a difficult spot. In a way, it’s very similar to the position the Fed has been in for the past several years. It has a mandate and an objective, but its tools are largely ineffective, and that makes them impotent. Well, that’s not completely true. The markets don’t actually realize they are impotent, and that leaves them with one weapon in their arsenal. The threat of action.
For years, the Fed has been struggling to contain the investment bubble while remaining as accommodative as possible in order to prop up a struggling global economy. Every time equities appeared ready to take off, the Fed would rattle their saber about possibly removing accommodation. The threat worked because market participants actually believed the Fed could/would do so, and that it would actually make a difference. Over and over again, they employed this same tactic.
I say OPEC is in a similar situation, because they don’t control their destiny nor do they have the ability to affect the price of oil in the same way they did before the big spike early this millennium. However, just as it has been for the Fed, market participants are slow to realize this. You see, the reason the price of oil is sinking, and is likely to continue to be weighed down, has less to do with supply than it does with demand. It is the demand side of the equation that is driving oil prices. It’s been the case since China began orchestrating the great urbanization and industrialization project in 1996. This is what makes this period unique. Whereas the majority of the relevant history of energy has been driven by a concentrated supply side, making OPEC powerful, now it is driven by the demand side. Well, that’s not completely true either. The concentration of power in energy production isn’t the same as it used to be. In response to the spike in demand and the elevated prices, the world began searching for more oil reserves, and particularly for alternatives. It found both, in very large quantities.
To make a long story short, OPEC doesn’t have the power to dictate the price of oil any more than the Fed has the ability to drive growth and inflation higher. The only real tool they have, is the threat of action. If they deliver on what they’ve threatened come November 30th, their impotence will be on display for the world to see. Imagine it for a moment. They deliver the cuts that everyone is expecting. Oil jumps back to the mid $50’s, maybe even $60. Then what? Believing that a new floor has been established, all that pent up supply that’s been offline because it wasn't profitable, will quickly come back online again. At the same time, global demand growth continues its downward trend, not because of industrial growth rates, but because the impact of China’s urbanization and industrialization process is finished, technology continues to make us more efficient, and we discovered fracking and massive oil reserves, neither if which can be undiscovered.
I know, Trump is going to spark an industrial revolution, triggering a huge increase in energy demand, right? Perhaps, but don’t forget, he’s also going to be unleashing a huge increase in supply. Restrictions on fracking, offshore drilling, and all other energy extraction techniques will be wiped away. What better way to make America Great Again, than to make it “energy independent?” Let’s not forget his comments re: the Iranian deal either. I’m sure the Iranians haven’t. Which is why they will be hesitant to reduce output while the threat of new sanctions hangs in the air. All of this, at a time when the market is already saturated. So, let’s imagine for a moment that OPEC does deliver the cuts, and then oil continues its descent. What will they do then? What will happen when the markets realize OPEC is impotent, that there is no one to keep it propped up? Which is why the best thing OPEC can do to prop oil up a little longer is to extend the threat a little longer. PS: The Fed remains impotent, which means price action triggered by it should be categorized as “noise”, and capitalized on accordingly.
Why Trump is Irrelevant
Donald Trump won the election. As a result, everyone is attempting to dissect his every utterance in order to properly set expectations for future policy actions. It’s a difficult thing to do because he’s been extremely vague, and inconsistent, not just since he began campaigning, but throughout his public life. He’s also known for a short attention span and having little interest in the details. However, he does have a history of outsourcing, and I’m not just referring to the production of his hats and ties. I’m referring to the outsourcing of just about everything except promotions. He outsourced business/legal details to Roy Cohn, authorship of his best selling book to Tony Schwartz and his politics to Steve Bannon. If you’re attempting to understand what a Trump presidency will look like in order to set expectations for the future, it’d be a good idea to stop following Trump’s tweets and stop listening to those who are making predictions based on Trump’s words and actions. Just as you’d be better informed to ask Roy Cohn about the details of a Trump business deal or Tony Schwartz about the inspiration for “The Art of the Deal”, you’ll likely be better informed about the policies of a Trump presidency by focusing on the words of Steve Bannon. However, in conversation after conversation with clients, especially those located overseas, it has become apparent to me that Bannon isn’t even on most people’s radar, except perhaps as a distraction. In an attempt to rectify that, here are two first person pieces that provide excellent insight into the man I believe is actually pulling the strings. (The fact that the articles are from BuzzFeed and The Hollywood Reporter is actually quite informative as well.)
Please, take a moment to read these pieces before going on so that what follows will have the proper context.
The Bannon Risk Premium
Bannon’s objective is to put the iron belt back to work. He believes this is an ideal time to carry out a trillion dollar stimulus plan, because interest rates are so low. The implication is that zero to low interest rates allow for borrowing that comes with little to no cost. With the money he raises, he wants to build shipyards and steel manufacturing plants, shifting power from the coastal, urban centers back to the traditional blue collar areas. He believes these jobs have been given away to foreign workers as a result of poorly negotiated trade agreements, and globalization in general. He admits that he doesn’t know exactly how this will play out, but is willing to risk it all because what has been done so far simply hasn’t worked.
At the same time, Team Trump has a very well established view that debt is a powerful tool for growth, and bankruptcy is a viable strategy for seeing it through. So, we have the key policymakers of the new administration who believe in massive borrowing in order to achieve very lofty, highly speculative goals with a winner take all, let’s see what sticks mentality. If it works, they are geniuses. If it doesn’t, it could have serious implications. Regardless of whether you weight the odds in favor of the former or the latter, as it relates to the task of setting expectations and a repricing of assets accordingly, one thing is clear. Economic policy expectations must be reframed so as to be observed through the eyes of the policymakers coming to power. Unfortunately, that’s unlikely to happen, and the reason is cultural.
For almost 20 years, we’ve observed experts getting the China story wrong for the same reason. Western economists have observed China through the lens of their own upbringing, their own schooling and experience. It led them to draw conclusions and make predictions about policy, and its results, that have been wrong year after year. Rather than acknowledge their mistake, their natural inclination has been to push harder, be more emphatic, and especially, put the blame on the misguided decisions of policymakers when they don’t match their predictions. Let’s be clear though. When we do this, the mistake is ours and we are the misguided.
If instead of making policy predictions based on our own views and beliefs, we do so based on what the policymakers are telling us, our predictions are more likely to be accurate. So what are my takeaways as they relate to Bannon? Well, perhaps the most significant has to do with the creditworthiness of the United States. Now before you go calling me alarmist or extremist, let’s be clear about what I mean. Creditworthiness is now, and always has been a factor in the pricing of debt instruments, even for the United States. For quite some time though, concern over the creditworthiness of the United States, for all intents and purposes, has been minuscule. Therefore, there hasn’t been a risk premium of any consequence. However, if the odds of a default to this point have been say, 0.01% (hypothetically), and they move to let’s say, 3%, that represents a significant jump. If you believe that a default would be accompanied by a significant repricing of US debt instruments, then even this seemingly insignificant move from 0.01% to 3% should represent a bump in risk premium required by investors to hold US debt. Traditionally, and rightfully so, risk premium should be greater the further out on a curve you go, since time represents compounded uncertainty. To summarize, as a result of Trump (Bannon) policy we should expect an increase in risk premium on US government debt that should shift the yield curve higher and steeper. This is distinct from expectations regarding inflation and demand, for it has less to do with economics than about “rule of law”. (OK, now you can call me extremist.)
Much more to cover as it relates to the global macro environment, but just as importantly, how to capitalize on it by reducing the potential for mistakes, in the coming days. PS: Rates have not broken the long-term downward trend channel. (See charts on next page)
"While everyone else is scrambling to answer who, what, where and when, Duneier is focused on explaining the 'why'."
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis and Behavioral Investing in the College of Engineering at the University of California. His book, AlphaBrain, is due to be published in early 2017 (Wiley & Sons).
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.
Learn how Bija's proven, proprietary approach to decision making helps the world's top institutional investors generate better results.