Economics, Energy crisis, Inflation, Market research, Market trends, Oil market, Policy, Risk management, Stock market, Trend following

Perfect storm gathering: the three converging disruptions

In the near future, we are likely to experience severe consequences of three converging disruptions:

  1. Stock market crash
  2. Oil price shock
  3. Inflation

Since the last recession we’ve enjoyed the longest ever period of economic expansion with low interest rates, low inflation and subdued commodity prices. But this all could be coming to an end.

Bursting of the “everything bubble”

Throughout the west, unprecedented government and central bank stimulus programs helped inflate the current “everything bubble.” This is not a new phenomenon; monetary expansion always creates asset bubbles. The one thing we know is that without exception, asset bubbles ultimately burst. The examples are many and some of them made a mark in the collective conscious of entire generations, from the 1630s Tulip Mania to the 1990s dot-com bubble.

The great Japanese bull market of the 1980s was in many ways similar to the current ‘everything bubble’. In view of the Japanification of western economies, revisiting this experience should prove instructive:

 

NK_82PctDDNAfter Japan’s bubble peaked in December 1989, the Nikkei fell into a two decades long bear market shedding 82%. More than 30 years later, Nikkei is still deep below 1989 levels. As uncomfortable as this is, Japan’s experience might be a foreshadowing of how the current bubble could unravel.

Oil price shock

Measured by historical standards, the price of oil has been extremely volatile in recent years. From over $114 per barrel in the summer of 2014 it collapsed over 75% in only 18 months’ time. Then it tripled to $86/bbl in October 2018, only to drop by 40% to $52/bbl two months later. In September 2019 oil experienced the single largest one-day price jump. The question is: why is the oil price so very volatile? Is the market forewarning us of greater disruptions in the future? A closer look into oil market fundamentals suggests that a great crisis could be in the making.

Oil supply fundamentals suggest that we are facing a serious crisis of oil scarcity. Producing countries, particularly OPEC members, have been vastly overstating their reserves. Oil production from conventional sources peaked between 2005 and 2009[1] with at least 37 oil producing countries already experiencing significant output declines. A chart prepared by the Energy Information Administration (EIA) for a U.S. Department of Energy conference[2] in 2009 shows the agency’s projected global production decline through 2030 against projected demand:

EIA_DecliningOilProduction_2009

EIA expected oil production to decline by about 4% per year. While crude oil from fracking slowed the decline somewhat, it is unlikely to impact this shortfall in a meaningful way. In fact, in spite of their earlier optimism, in its 2014 World Energy Outlook, the EIA warned that the U.S. shale boom in fact masked the threats to world oil supply and that global energy system is in danger of falling short of expectations. This was a polite way of saying that we are in serious trouble and that fracking won’t save us.

These conditions are taken with utmost seriousness by western political and military organizations. They have led the UK’s Ministry of Defence to predict[3] that oil price could rise to as high as $500 per barrel over the next two decades, causing crises of unforeseeable proportions. German[4] and American[5] military analysts broadly agreed with the British assessment. In fact, concerns about access to oil could be among the ultimate causes of the escalating geopolitical tensions we’ve observed over the recent months and years. This could well turn out to be among the most important developments facing humanity for decades to come.

Inflation

Runaway inflations tend to emerge when an economy’s debt burden becomes unsustainable, usually as a consequence of too much government spending and too much war. Today, nearly all categories of debt in the U.S. economy are breaking records: government, corporate, as well as household and student debt. Worse, the levels of delinquency have been rising and credit standards have been deteriorating over the recent months, particularly for corporate debt. And while high inflation is not yet a reality, inflationary pressures are building within the European and US domestic economies and represent an important risk.

Warren Buffett rightly warned that for a debtor nation, inflation is the economic equivalent of the hydrogen bomb. It is the most formidable destroyer of wealth. Since 1960 over two thirds of the world’s market economies suffered episodes of inflation which exceeded 25% in at least one year.[6] On average, investors lost 53% of purchasing power during such episodes. Periods of high inflation can span up to a decade, causing wholesale destruction of wealth, as the following examples illustrate.

High inflations cause massive wealth destruction
Inflation experience 10-year inflation rate (annualized) 60/40 stock/bond portfolio real return (annualized) Decline in real portfolio value
USA (1972 – 1982) 9% -3.5% -65%
UK (1910 – 1920) 11% -9.3% -86%
Japan (1946 – 1956) 23% 3.3% -52%
Source: Alliance Bernstein, “Deflating inflation – redefining the inflation-resistant portfolio,” April 2010.

Although we can’t predict inflation’s timing or severity, significant changes in inflation almost always come as a surprise. For example, an oil price shock could trigger the cascading changes leading to an acceleration of inflation. In fact commodities in general seem ripe for a large-scale price readjustment relative to other assets: they are the only asset class whose prices didn’t inflate in the current cycle along with the others. To the contrary, commodities remained relatively depressed reaching their lowest level in 50 years relative to equities.

201907_CommmoditiesToS&P500Ratio

The imbalance between commodities and equity prices could be like a slingshot stretched to the limit and ready to snap back in the opposite direction. By merely reverting toward their historic norm, commodities could trigger severe economic and social disruptions including high inflation.

Protecting your wealth from inflation

In a speech at the New York Fed, [7] economist Robert Wenzel told the central bankers that, “… vast amounts of money printing are now required to keep your manipulated economy afloat. It will ultimately result in huge price inflation, or, if you stop printing, another massive economic crash will occur. There is no other way out.” Mr. Wenzel is right, there really is no other way out and the inflation risk is very real.

Commodity futures: the best hedge against inflation

Multiple empirical studies showed that managed futures represent by far the best hedge against inflation. For example, in the article, “Assessing Managed Futures as an Inflation Hedge within a Multi-Asset Framework,”[8] the authors found that, “Managed futures outperform the other asset classes… No other asset class presents itself as a viable inflation hedge.” An earlier study by Alliance Bernstein corroborated these findings, as the following graph shows:

InflationBetaByAssetClass

The empirical evidence in these studies simply corroborates what common sense suggests: when inflation takes off, commodity prices soar. They do so in the form of trends that can be reliably exploited using systematic trend-following strategies.

CONCLUSION

Bursting of the “everything bubble” is only a matter of time. With rising levels of debt, its deteriorating quality and record high asset prices in western economies, the risks are high. In the words of Elliott Management’s Paul Singer, “The first whiffs of either commodity inflation or wage inflation … may cause a self-reinforcing set of market events … which may include a sharp fall in bond prices, … fall in stock prices, rapid increase in commodities…” When – not if – such a self-reinforcing set of market events takes place, the loss of investor wealth will be very dramatic.

Business-as-usual investing is rife with risk. To preserve their wealth, investors should seek to diversify their portfolios out of the overinflated asset classes and strongly consider gaining meaningful exposure to assets like energy, metals and agricultural commodities. The best way to do this is by using systematic trend following strategies in a diverse set of futures markets.

ISystemTrendFollowingWithURL

This is the investment strategy I can propose, based on a proven investment process and technology that has enabled me to consistently outperform my strategy benchmarks between 2007 and 2019 and deliver high investment returns (+27% net of fees) when the last asset bubble burst. If your investment portfolio is under $1 million, acquiring a plot of farmland or gold bullion (enough to cover a few months of your living expenses) might be advisable. You’ll also be better insulated from the crisis if you live in a community that has an economic base with continuity stretching back to before the industrial revolution and can sustain itself even when supermarket shelves go empty.

 

Alex Krainer is a commodities trader and author based in Monaco. He wrote the book “Mastering Uncertainty in Commodities Trading.”

Trading and hedging commodity price risk

[1] In its 2010 International Energy Outlook, EIA proclaimed that oil production from conventional sources probably peaked in 2006.

[2] “Meeting the World’s Demand for Liquid Fuels – A Roundtable Discussion” – U.S. EIA, April 7, 2009 – http://www.eia.doe.gov/conference/2009/session3/Sweetnam.pdf

[3] “Strategic Trends Programme: Regional Survey – South Asia out to 2040,” UK Ministry of Defence – Development, Concepts and Doctrine Centre (DCDC), October 2012. – DCDC is MoDs think tank within the Defence Academy site at Shrivenham. – The report utilised the input of a range of government agencies and departments, including the MoD’s Strategy Unit, the Defence Science and Technology Laboratory, the Cabinet Office, and the Foreign Office – as well as two private institutions, Standard Chartered Bank and Now & Next. Report: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/49954/20121129_dcdc_gst_regions_sasia.pdf

[4] Bundeswehr Transformation Centre – Future Analysis Branch: “Armed forces, capabilities and technologies in the 21st century: environmental dimensions of security” – Nov. 2010 – www.energybulletin.net/sites/default/files/Peak%20Oil_Study%20EN.pdf.

[5] Energy Trends and Their Implications for U.S. Army Installations” – U.S. Army Engineer Research and Development Center (ERDC), U.S. Army Corps of Engineers, September 2005 – unfortunately, this report is no longer available. An article about the report – “U.S. Army: Peak Oil and the Army’s Future” is available at http://www.resilience.org/stories/2006-03-12/us-army-peak-oil-and-armys-future

[6] Stanley Fischer, “Modern Hyper- and High Inflations,” National Bureau of Economic Research Working Paper No. 8930

[7] Robert Wenzel, “My Speech Delivered at the New York Federal Reserve Bank.” Economic Policy Journal, 25 April 2012. http://www.economicpolicyjournal.com/2012/04/my-speech-delivered-at-new-york-federal.html

[8] J. Twomey, J. Foran and C. Brosnan, “Assessing Managed Futures as an Inflation Hedge within a Multi-Asset Framework,” The Journal of Wealth Management, Winter 2011.

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