Current Economic/Market Flashpoints

Unprecedented debt accumulation in China, US, Japan, Australia, UK and other places.

The large decline in oil decimates one of the primary drivers of growth in the US.

The large decline in commodity prices due to the slowdown in China crushes Canada, Brazil and Australia.

Large residential real estate bubbles in Canada, UK, Australia, NZ and China undermine banks in those countries.

QE in Japan and by the ECB sets up a race to the bottom in the currency wars. US can't exit QE because it would blow apart global currency markets.

NIRP set up incentive structures leading to asset mispricings and misallocation of resources.

Financial repression and the failure to reform or clear markets is manifesting in deflation. 

Geopolitical instability with potential spillover effects: Ukraine, Syria, Grexit, oil squeeze on Iran & Russia.

Inequality and Political Change

Research Affiliates posted an interesting article today titled, "The Profits Bubble. "

The gist was that outsized profits are controlled (or allowed) by government and when they get too big (there is a trade-off between profits and income), the resulting growing inequality leads to social unrest and political change. The article correctly argues that profits cannot grow at a faster rate than the economy for too long and established that they have been growing at a faster pace than the economy for the last 20-30 years.

I think this idea/notion is correct. The problem is one of timing. It is very hard to know when or what the last straw will be that has been added to the camel's back. Changing societal/cultural norms and rising living standards around the world (rising economic tide in developing world, falling cost of living in developed world) are likely to make this process alot longer than prior history examples (maybe).

Societies are just like markets inasmuch as they are tightly coupled complex systems prone to periodic crisis and unravelings.

Back of the envelope energy calculations

I don't know the energy sector very well, but I come across interesting cost numbers every now and again.

I saw an article today that talked about the avg. Eagle Ford/Bakken shale/oil well producing about 400 barrels a day with decline rates of 50% per year. The article estimated the all-in cost of extraction/production was as high as $75/bbl.

I have heard the cost to drill a well varies between $5m-$10m (up from $1m to $3m less than 5 years ago).

Assuming the price of oil is $100/bbl and those estimates are about right, the economics are approximately:

Year 1: $100-$75 = $25/bbl margin x 400 x 365 = $3.65m profit
Year 2: $25/bbl x 200 x 365 = $1.825m profit
Year 3: $25/bbl x 100 x 365 = $912k
Year 4: $25/bbl x 50 x 365 = $456k
Year 5: $25/bbl x 25 x 365 = $228k
Total Profit Over 5 Years = $7.07m
Discounted at 12%
PV = $4.01m

Interesting.

P.S. From a USA Today article 11/4/13 "Tight oil development is still at an early stage, and the outlook is highly uncertain," says the Department of Energy's EIA in its Annual Energy Outlook 2013, adding its future will depend on how individual wells perform as well as their costs and the revenue they generate.

The reason: "sweet spots" — small areas with the highest yields. Hughes says these spots simply don't last long. Unless more wells are drilled, the Bakken shale of North Dakota and Montana loses 44% of its production after a year and the Eagle Ford shale of Texas, 34%. Most of the nation's major shale regions produce both oil and gas.

The Next Inflection Point

Getting the big picture right is one of the most important things an investment manager/strategist can do. Anticipating and timing an inflection point, a move from one regime to another, is where reputations are made and the greatest value addition can be achieved.

Post global financial crisis (GFC), the world has been mired in a debt enduced deleveraging. This has undermined confidence, weighed upon the economic fabric, and forced governments to lever-up to make up for private sector slack. Fiscal sector tailwinds are coming to an end. Financial markets are hanging on continuing monetary stimulus to prop up markets. Confidence is in short supply. The hope is that the monetary authorities, in conjunction with sufficient deferment, obfuscation, and can kicking from their fiscal partners, will get us through to the other side. With potholes everywhere (cue Europe, China, US problems), the future is still highly uncertain.

One scenario that could play out is a recovery in credit. US bank balance sheets have largely been rebuilt (the same is not necessarily true of their European counterparts). At some point they will be tempted to take advantage of the competitive opportunities, and in classic follow the herd fashion look to put money out the door. A devolution of reserves and rapid credit creation by financial entities could well be the catalyst that helps turn the corner. With confidence being the most lacking ingredient, wealth and prosperity illusions created by money creation could be just what the doctor ordered.

Will this scenario transpire? Possibly. When is it likely to happen? In 2013 if we continue on our current economic trajectory (many commentators have pegged 2013 as an inflection point of a negative kind). How long will it last? If it happens, I suspect 2-4 years. Will a renewal in growth trend be sufficient to overcome secular headwinds further out (rising interest rates, deteriorating fiscal profile, higher taxes)? It'll be a battle.

As yet, I don't think we have solved our fundamental structural problems within the global financial system. That having been said, if a blast of confidence comes flowing through the system on the back of banks being more willing to take a risk, there is a chance we experience a positive feedback loop that translates to real growth, and the possibility of getting out ahead of our problems. A major catalyst for that scenario is resolution of the developed world's fiscal financial path. Not only does it require confidence, but it also requires real leadership. Two traits in fairly short supply at present.

No signs of it yet. But keep an eye out for a change in conditions.

I've Got To Confess...

...all this talk about "the failure of capitalism"* and the "need to reinvent capitalism", etc., etc. seems to me pure gibberish. One, it doesn't need to happen. And two, it isn't going to happen. We may get a little regulation here, a little limitation there, but I doubt very much we have a wholesale reinvention of the global economic system.

What we are seeing, in this financial crisis and the markets response to it, is capitalism in action. To me, the beauty of the capitalist system is that the laws of economics are allowed to operate somewhat freely (by the way, the laws of economics operate within all economic systems). Given that the system is predicated upon self-interest (not a great moral foundation I might add), it also needs reasonable safeguards and constraints to protect consumers, and ensure that bad apples and bad actions have consequences. But if you live beyond your means and you get swept up in the euphoria of the masses (and fail to assess risk appropriately), then there is an inevitable price to be paid. No system can stop you from making dumb decisions. But the capitalist system seems most reasonable from the perspective of economic efficiency and wealth creation. Issues of wealth distribution and equity are generally best dealt with through the political system.

*The discussion about capitalism is full of hyperbole and ridiculous assertions on both sides. Things such as, "if you believe in capitalism you believe the market is always right and should be given free reign," and "capitalism is morally bankrupt and the cause of all evil," etc. Such comments are ridiculous on their face, and should be treated with the contempt they deserve (by ignoring them).

Allowing the Market to Clear

Perhaps my biggest problem with the bank bailouts, fiscal stimulus and quantitative easing is the idea that these artificial insertions impede the clearing of markets.

Closely associated with this idea, is the notion that "there is no such thing as a free lunch."

The possibility* that there is no such thing as a free lunch concerns me, because we are then left with the "law of unintended consequences" (and these could be great).

*it is, in fact, as close to an immutable law as you will get in economics