Taal selectie

Sell in may and go away

"Sell in May and
Go Away" ?

Pascal Blackburne & Luc Synaeghel 2019-05-01

With little risk that central banks deviate from their accommodative stance – save perhaps a scenario of victory of the left in the European elections and subsequent German takeover of ECB leadership – risky assets look set to pursue their upward path, at least through the end of this year and of course conditional on a good outcome to the difficult, but still ongoing, trade talks between the US and China.

Notwithstanding President Trump’s numerous tweets, a US-China trade deal still looks the most probable scenario, but it will take time after last week’s events. Reportedly, such a deal would involve multi-year Chinese buying of US soya beans and oil (in the trillion-dollar range), giving President Trump the big short-term win he needs, while actually mattering little to China (the country needs these commodities, wherever they come from). On the intellectual property front, it appears that the Chinese will agree to some form of protection – which is also not a big issue for them since by 2025, when the staged-process is fully rolled out, they will have taken firm leadership of that space. In exchange, the US will have to repeal most existing tariffs.

A quick deal now being off the table, some volatility must of course be expected. That said, as long as the easy money environment prevails (i.e. until inflation rears its ugly head), investors will inevitably be drawn back into risky assets – never mind the valuations. The maths is really quite straight-forward: with a near-zero 10-year yield on German government bonds, investing in a stock that pays a 3% dividend per annum means that no money will be lost even if the stock’s price were to lose a third of its value over the period.

Our current bullish stance on equities does not mean that we ignore the negative side effects of dovish central banks policies. The ongoing IPO frenzy is just the latest manifestation of money pouring into companies that would in earlier days not have secured financing – or not for so long – and are in turn putting massive pressure on traditional rule-abiding companies. As we detailed in a prior investment letter, the process of creative destruction has literally been turned around. Eventually, a tipping point will be reached: either the financing stream is cut off and many “new tech” companies go bust, or enough traditional enterprises are blown away that “new tech” companies become the norm and can impose pricing power on consumers (such as Zalando starting to charge for delivery). Needless to say, neither scenario will appeal to financial markets. Rising inequality is another very worrisome consequence of easy money that we have oft pointed to. Below, we suggest how (very much needed but politically difficult to finance) infrastructure spending could be a means for the wealthy to reduce the gap and appease social tensions.

But for the time being, let us continue to hold on tight to investments that have yet to deploy alpha, notably shale oil stocks, perhaps shifting some Asian equity exposure from Japan to China and, for risk management purposes, taking some profits in the high yield bond space, where our opportunistic investment in early January proved very timely.

European Elections Preview

With European elections just a fortnight away, it is still very difficult to assess what their outcome will be. One scenario that we would watch out for, because it could darken the interest rate picture and thus wreak havoc with investors’ appetite for risk, is a victory of the left – leading to Dutch Socialist Frans Timmermans being voted President of the European Commission, rather than German Centre-Right Manfred Weber. Should that be the case, Germany would not doubt lay down a claim to the ECB Presidency, when Mario Draghi’s eight-year (non-renewable) term expires at the end of October. Germany’s candidate? Jens Weidmann, current Bundesbank Chief.

In turn, this would mean a move to less fiscal austerity (driven by a leftish European commission, as well as pressure from extreme parties in the European parliament) counteracted by tighter monetary policy. Remember that Germany – unlike most of the Eurozone – would be able to bear higher rates, its public debt to GDP ratio being relatively low.

The irony is that if the left were to win the European elections, it would be because of the British finally taking part in the vote. Indeed, the delayed October 31 deadline for Brexit means that UK-elected members of the European parliament will get to participate in the choice of the next European Commission President, even though they will not actually see him or her in action (the new term begins on November 1st).

Odds of a Large US Infrastructure Spending Program

In the US, given that infrastructure is one of the few topics on which President Trump and the Democrats see eye to eye, the recent agreement on the need for USD 2 trillion of spending was both unsurprising and positive. That said, chances of finding common ground on how to finance such spending, hence of a bill actually passing through Congress, appear low. In order to avoid the budget deficit from ballooning further, the Democrats will want to raise taxes, whereas the Republicans will want to cut other expenses. Difficult to see any room for compromise there. As for allowing the deficit and government debt to swell, this might be fine with President Trump, and with all proponents of Modern Monetary theory, but not with the main wing of his party.

In this context, we were interested to note that the just-held Milken Institute Global Conference, a Davos-like summit for the super-rich that takes places every spring in Los Angeles, was entitled “driving shared prosperity”. Recognizant of the rising inequality and related social unrest, participants effectively adopted a proactive approach as to how they will be able to avoid having their money “confiscated” at some point.

What if investing in infrastructure were to be a solution? After all, it involves putting money towards a cause, with a specific goal and measurable results – as well as leaving some form of heritage. To a certain extent, it is akin to the philanthropic undertakings of Silicon Valley billionaires. And the speed with which affluent French families pledged large funds to the rebuilding of Notre-Dame-de-Paris certainly suggests that it is an idea that could gain traction.

The Disconnect Between the Oil Price and Shale Producer Stocks

WTI XOP

Source : Bloomberg

Oil stocks continued to lag the commodity in April, with the WTI price gaining a further 6.3%, to almost USD 64 per barrel, and the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) of US shale producers posting a flat return. The disconnect dates back to early January and has since gradually expanded to over 25% (see chart).

Explaining this performance gap is difficult. A possible interpretation is that investors fear a renewed oil price collapse or are scared that environmental concerns will eventually hit the sector (in the post-Trump era).

With sanctions against Iran now in full force, OPEC/Russian production complying with the agreed cuts, Venezuelan output in free fall, and oil demand still strong, we see no reason to fear a serious oil price correction in the near term. On the contrary, production having fallen below consumption, large oil inventory drawdowns are likely to occur once refineries come out of their maintenance period at the end of May and run at the full capacity required to provide new low-sulphur fuel and much greater quantities of marine diesel oil for the shipping sector, as well as gasoline for the US driving season.

The disconnect cannot be a matter of valuation either. At the current oil price, shale producer stocks are trading at an expected 2019 EV/EBITDA multiple that averages 5x (6x for the larger companies, 4x for the midsize and small companies) and an estimated 25% discount to net asset value (15% for the larger companies, 35% for the midsize and small companies). Should oil rise to USD 75 per barrel, and shale stocks not follow suit, the estimated discount to net asset value would exceed 50% on average.

Such large undervaluation has not gone by unnoticed by the major oil companies: Chevron recently made a bid on Anadarko Petroleum, one of the bigger shale oil producers, at a premium of roughly 35% to its stock market price, followed by an even higher bid by Occidental Petroleum, at a premium exceeding 50% (see chart).

anadarko

Source : Bloomberg

After a couple of years of very low exploration spending – due to the oil price having dropped below the production cost price of new deep-sea projects – oil majors are currently cash-rich and looking to expand their oil reserves. The most certain and interesting way to achieve this goal is to buy (cheap) US shale companies, as opposed to investing in the exploration and exploitation of deep-sea projects that will take at least five years to come online. Shale oil reserves are proven and ready to drill. It takes only a couple of months to be in production mode and the larger part of the wells can be exploited within three years. As such, majors can avoid the longer-term oil price risk related to upcoming renewable energy and changes in environmental laws.

Further bids by majors on independent US shale companies are thus likely in the near future, which could (finally) serve as the catalyst to much higher stock prices in the sector.

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