06 Jul Lazy Herds (Q4-20)
“It is really quite amazing how time horizons and money goals can change when there are stocks around that are going up 100 percent in six months.” – Adam Smith, 1967
It has been a wild time for markets. In 2020, stock markets around the world endured their steepest crash in history due to an unthinkable global pandemic, only to rebound in the steepest recovery ever recorded largely due to unthinkable amounts of monetary and fiscal stimulus. In the middle of March 2020, at the height of the risk-off environment, nearly every asset class became dysfunctional and unhinged from past performance behaviour. For example, between March 9 and 26, the yield on the 10-year Government of Canada bond nearly doubled from 0.54% to 1.04%, the FTSE Canada Universe Bond Index1 fell 6.5%, leveraged loan spreads exploded +1,000 basis points, and gold, the quintessential safe-haven asset, suffered a decline of 12.5%. Investors suffered whiplash – credit spreads tightened back in just three months, after central banks pledged to effectively backstop anything and everything credit-related, from sovereign Treasuries (in order to lower overall market interest rates), investment-grade corporates, mortgage-backed securities and, in the case of the U.S. Federal Reserve (the “Fed”), even high yield bonds. As credit analysts at KKR recently pointed out to investors, on March 23, over 80% of the U.S. credit market yielded greater than 7%, and by the end of the second quarter, only 27% of the market yielded greater than 7%. The broad rally in risk markets went into overdrive in the fourth quarter, fueled by optimism around COVID-19 vaccine developments. At the end of 2020, only 16% of the U.S. credit market yielded greater than 7%. In an incredible reversal of fortunes, most asset classes finished in the green in 2020. The S&P 500 was up 16.23%, the S&P/TSX up 5.6%, U.S. high yield up 6.17%, U.S. leveraged loans up 3.12%, and the FTSE Canada Universe Bond Index up a robust 8.7%, three times its annualized return over the past ten years.
Technology was the sector most responsible for leading equity and credit markets out of the red in 2020. Technology companies were largely unaffected by the pandemic and instead enjoyed a strong tailwind from the acceleration of existing trends calling for digital transformation in online communication platforms, cloud services and e-commerce. This digital paradigm, however, does not mean technology companies have unlimited value. Many tech stocks that listed publicly through high-priced SPACs2 doubled or tripled their price in a day, with many investors seemingly oblivious of the fact that the underlying companies were often not profitable or even operational. Reminiscent of the late 1990s, public market company enterprise values are an eye-watering 8 turns higher than comparable private company enterprise multiples (as a multiple of EBITDA).3 The rally in tech stocks today looks grossly overextended and is being primed again by retail investors; however, this time, retail investors have stimulus checks and zero commission trading accounts and can own fractional shares in companies through online brokerages, no longer making stock price a barrier.
Goldman Sachs research found that in 2020, U.S. stocks favored by retail investors (like Tesla) outperformed those favoured by institutional investors and did dramatically better than the overall market by nearly 5 times. Segments of the equity markets have turned into online casinos. The volume of out-of-the-money single stock call options with less than two weeks to expiration have exploded. Institutional investors rarely buy such options, which are not much different than bets on a roulette wheel. Margin debt – the amount of money that investors have borrowed in order to buy stocks – is now at the highest level ever, in both absolute terms and relative to U.S. GDP.4 Historically, peaks in the ratio of margin debt to GDP have been harbingers of market crashes (like 1987, 2000, 2007, and today).
2020 was unquestionably a dramatic year filled with fear and uncertainty. In uncertain environments, people always feel more secure in herds. During the pandemic, for example, investors have preferred herding rather than being wrong about a decision on their own. Human minds are lazy and prefer decisions that require the least cognitive effort. According to Daniel Kahneman, acclaimed psychology professor and author of the best-selling book “Thinking Fast and Slow”, laziness is built deep into the nature of people: “If there are several ways of achieving the same goal, people will eventually gravitate to the least demanding course of action. In the economy of action, effort is a cost, and the acquisition of skill is driven by the balance of benefits and costs.” When in fear, people tend to expend even less effort (a “paralysis” sets ins), which partially explains why human beings tend to copy others and be conformists rather than innovate and separate from the pack. So, when millions of small retail investors start posting their intentions to buy a particular stock on online forums, more investors became inclined to the proposition even if it was irrational for fundamental reasons. The crowd gets larger as the stock moves higher and farther divorced from reality. For investors, nothing eases worries more than easy money. As John Maynard Keynes posited in 1935, contagious “animal spirits” move markets. Investors will need to break from the herd if they are going to avoid being prey when markets eventually crash.
Good Yield Hunting
Ultra-low rates are increasing the challenge for fixed-income investors to find income without taking on uncomfortable levels of risk. While total U.S. institutional leveraged loan issuance in 2020 was $287.8 Billion, down 7% from 2019, the share of highly-leveraged loans issued by borrowers (rated B-/B3) was at its highest rate ever, at 36% of volume and up 9% in issuance compared to 2019. By Q4-2020, the risk premium on highly-leveraged loans (senior debt to EBITDA >5x) over less leveraged loans (senior debt to EBITDA <3.5x) was just 74 bps but enough to dominate issuance and investor appetite. With Treasury yields in the U.S. and Canada still near record lows, and historic policy changes by central banks to keep rates low even if short term inflation or GDP spikes, credit will be generally impeded of its ability to generate much incremental return. As we have repeatedly recommended, relying on passive top-level exposures to credit in the current environment will lead to losses. Investors need to understand credit fundamentals on an issuer-by-issuer basis and preferably outside traded markets where sourcing and selection are more inefficient and therefore fertile for higher returns.
Government stimulus extended the credit cycle and delayed the distressed wave but it has not eliminated the cracks surfacing among highly-leveraged issuers and those operating in industries that will struggle to adjust their business models to fit a new post-pandemic world. In the U.S., the Fed’s decision to buy high-yield bonds as part of its good intentions to keep capital markets functioning has had the perverse effect of benefiting larger issuers and creating a false bifurcation between perceived high-quality credit and storied names. Take for instance, issuers in the leisure industry which constitute the most troubled loans in the S&P/LSTA Leveraged Loan Index. These loans returned -2.63% in 2020; yet high-yield loans in the same industry were +0.78%. Large leisure companies, notably cruise lines such as Norwegian, Viking, and Carnival, which were previously solvent entities hit hard by the pandemic, were able to make multiple trips to the high-yield markets to extend maturities, borrow at attractive rates, and bolster liquidity. Smaller leisure companies, which rely on bank loans, have not been able to take advantage of the same opportunity. The dispersion in traded credit markets caused by the Fed’s selective moral hazard provides an advantage to credit investors willing to put in the hard work to hunt for attractive yields.
Oil market fundamentals today may be the most constructive in over a decade. Global oil markets are driven primarily by either demand (e.g., emerging market growth, COVID-19 destruction) or supply (e.g., U.S. shale growth, OPEC policy, Saudi-Russia price war), but rarely by the simultaneous occurrence of both.
In the U.S., the New Year began with oil demand of 19.7 million barrels per day (mbpd), which is within 1.2% of its level in January 2020 and within the range of demand for the past five years. More recent data published by the U.S. Energy Information Administration (EIA), prior to the polar vortex that ravaged Texas, shows U.S. oil demand rose even further to 20.7 mbpd representing growth of +5.4% year-over-year. Oil demand also appears to have recovered globally; for instance, China’s oil imports rose 18% month-over-month in January 2021 and India’s oil demand neared its pre-pandemic levels. In fact, EIA estimates that global oil demand rebounded to 96.7 mbpd in February 2021 to within 1.0% of its February 2020 level of 97.7 mbpd. Global oil demand has continued to exceed supply since the third quarter of 2020. EIA currently projects that global oil demand could grow by 8.9 mbpd over the next couple years (5.4 mbpd in 2021 and 3.5 mbpd in 2022). If these projections are accurate, it would represent the largest two-year global oil demand increase on record since 1950.
Bolstering the demand side is higher vaccine distribution and massive fiscal stimulus, much of it in infrastructure spending planned under the Biden administration in the U.S. According to the Washington Post’s vaccine tracker,5 approximately 50 million people (or ~15% of the population) in the U.S. have received at least one dose of a vaccine. An average of approximately 1.65 million does per day are being administered currently with expectations that virus mitigation measures such as lockdowns and mobility restrictions will become mostly unnecessary by the summer. Global lockdown measures caused unprecedented declines in transportation, which accounts for ~56% of global oil demand according to the International Energy Agency (IEA), an autonomous inter-governmental organisation within the OECD. Global aviation activity fell more than 60% by the end of Q1-2020 and almost came to a halt in some countries. Road transport dropped between 50% and 75% in the U.S. as lockdowns spread. Vaccine distribution will help release high pent-up demand for travel (including from planes, trains, and automobiles). Indications from U.S. airlines such as Delta Airlines advising of increased summer travel bookings and the U.S. Transportation Security Administration hiring more than 6,000 security officer positions by June 2021, show travel is set to rebound.
The fiscal stimulus package and infrastructure plan of the Biden administration is expected to cause oil consumption to rise, at least in the near term. The new President’s first day energy-related executive orders were largely inconsequential to oil producers. The subsequent order halting all new permitting and leasing on Federal acreage, among other measures, was widely anticipated and, because it does not limit activity on existing leases, will have minimal impact on oil and gas production in the near term. If leases on Federal land are not subsequently renewed over the next 2-3 years, U.S. oil production could be reduced by 300,000 bpd according to S&P Global. Energy consulting firm, Rystad Energy, believes that any “green” focus of the Biden infrastructure bill will be mostly additive to oil demand in the U.S. due to increased construction activity, creating upside in 2021 of approximately 60,000 bpd, before rising in 2022 to 330,000 bpd. Depending on the scope and success of the various renewable projects planned by the government, particularly around solar, the risks to conventional energy are mostly limited to medium-term oil demand.
A steepening backwardation in global oil benchmarks is indicative of a market that expects a significant tightening and potential shortage of available barrels as global inventories are depleted to below-normal levels in the near term. OPEC 2.06 has communicated plans to normalize inventories but any increase in output is likely to be modest, at least until the demand recovery becomes durable. The supply response outside OPEC 2.0 may be more muted given limited access to capital, resource exhaustion, and the altered priorities of major producers. Annual conventional oil production is approximately 25 billion barrels per year, but recent discoveries have been averaging close to 5 billion barrels per year, creating a situation where most of the production decline offsets from existing wells will have to come from enhancing oil recovery from already producing fields. Drilling productivity in the major shale basins in the U.S. and in Canada’s WCSB have been rapidly declining since 2019 and total production has plateaued globally. New discoveries are also lagging – in the last one hundred years there has not been a single year when new conventional oil discoveries surpassed production. The annual new discovery to production ratio deficit, combined with lower field productivity, means that total global conventional production is moving from a long plateau to a steady and permanent decline trend in the next few years.
Despite recent higher spot oil prices, capital spending guidance from the largest oil producers continues to be pushed lower. Part of this may be due to the brief Saudi-Russia oil price war from March 2020 still remaining fresh in mind, but enormous investor and societal pressures to transition away from oil are influencing where energy companies invest. Companies with significant energy exposure have been penalized and encouraged to divest those assets because of a vision of a decarbonized world. It is peak gloom for energy producers. A year ago, we acknowledged in our Q4-2019 Investor Report that the energy transition was “a powerful downward force on oil and gas investments” that would likely “take decades” to play out. We also proclaimed that energy investments looked “remarkably inexpensive”. We are extremely well positioned today to benefit from higher prices and believe that the forces of supply and demand are now working in tandem to spark a new supercycle for the global oil market.
 The FTSE Canada Universe Bond Index measures the performance of the Canadian Dollar denominated investment-grade fixed income market, covering Canadian government, quasi-government, and corporate bonds. The index is designed to track the performance of marketable government and corporate bonds outstanding in the Canadian market.
 SPACs are special purpose acquisition companies formed for the sole purpose of raising investment capital through an initial public offering “(IPO”), which is then used to acquire one or more unspecified businesses to be identified after the IPO.
 Partners Group, Switzerland, June 2020
 From research compiled by Hussman Strategic Advisors
 OPEC 2.0 is a group of 24 oil producing countries that controls about 60% of the current world supply. OPEC currently includes 14 countries: Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Congo, Saudi Arabia, UAE, and Venezuela. The non-OPEC signatory countries are: Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russian Federation, Sudan, and South Sudan.