52 seconds capital

Month: October 2023

The International Energy Agency (IEA) released its Annual World Energy Outlook Report this month.

In a clear break from its past reports (in which timelines estimating peak demand were never referenced), the International Energy Agency (IEA) has, in this year’s report, projected that the demand for fossil fuels (oil, natural gas and coal) will peak well before the end of this decade.

It is ironical then that this very month also saw two of the biggest oil deals: ExxonMobil and Chevron, both using their pricey shares as currency, acquired Pioneer Natural Resources Company and Hess Corporation, in one fell swoop, for $60 billion and $53 billion respectively.

That’s an incredible $113 billion bet by the American energy giants that global consumption will remain well above the current 100 million bpd and peak demand is still many decades out.

Further, in a sign of how widely dispersed energy demand forecasts could get, OPEC, earlier this month, released a forecast projecting oil demand to reach 116 million bpd by 2045!

So, what gives?

By doubling down on investments into hydrocarbons, are the American oil companies’ doing a volte face on their Climate Change commitments? Was Engine No. 1’s activist stance at Exxon just a smokescreen? A mere attempt at greenwashing?

Not really.

On the contrary, I believe, the massive size of these acquisitions creates some clarity ─ for investors in stocks of US Oil firms ─ on how the American Oil Industry intends to deliver upon its climate change goals while balancing shareholders expectations around investment returns over the long term.

The American Oil Industry is, from hereon, more likely to continue to seek mega-oil deals to improve efficiency, while expanding acreage.

while European Oil majors like Shell, bp and TotalEnergies, hemmed in by their governments, are tilting their balance-sheet investments towards renewables and reducing their revenue exposures to fossil fuels, the US oil industry appears to have made their intent clear to hold onto their fossil fuel portfolios, while investing in ‘carbon capture and storage related technologies’ alongside.

As a technology, ‘carbon capture and storage’ is still in a nascent phase, but over the next few years, Financial Market Participants may expect the [Oil + Carbon Capture Tech] to be a constant buzzword in the earnings calls and management commentaries from US Oil Majors.

By

Avinash Menon, CFA

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The VIX, trading at 21.71 currently, has spiked up 26% during the last 30 days.

Considering its still down 5.2% when viewed on a YTD basis, that 26% spike appears to be nothing more than mean-reversion when viewed relative to its long-run average of 20.

Yet, the current levels of VIX when viewed against its Sep 14 low of 12.82 translates to a stunning 70% spike!

Speaking metaphorically, a 70% spike in the VIX (also referred to as a Fear Gauge) is akin to the markets tracing an icy finger down an investor’s spine.

Well, despite that spike in VIX, there aren’t any visible shivers in the US Equity Markets (the US-matched-cash-equity-volumes has not spiked up substantially, its unlikely to top 42 billion shares by close of this month, and could be well below the record high of 49.79 billion shares traded in March during the banking crisis when the VIX spiked to 26.52, its highest ever this year, unless of course the markets experience an extraordinary break in these last few days of October).

One possible explanation for this muted dread appears to be the investor’s fascination with a newly discovered pocket of uncertainty: the whipsawing treasury yields and a budding interest (forgive the pun!) in VIX’s nondescript forgotten sibling – The MOVE Index.

In simple terms, what the VIX is to stock price volatility, the MOVE is to interest rate volatility.

The MOVE index calculates the implied volatility of U.S. Treasury options using a weighted average of option prices on Treasury futures across the 2-, 5-, 10-, and 30-year maturities.

While MOVE isn’t as mainstream as VIX (which is puzzling since the US stock market sizes up to $46 trillion in market cap while the global bond market sizes up to $133 trillion) it’s emerged from a really long winter – a winter characterized by Central Banks worldwide guiding ‘interest rate certainty’, negative real yields and unlimited QE to supress long term yields.

Invert those long-term Central Bank moves and you realize why we are perhaps witnessing the very beginning of spasmodic moves (what is with the puns today 😃) in the MOVE index.

The MOVE index trades at 135.45 currently, its highest level since late 2008.

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Javier Milei, Argentina’s leading candidate, in the presidential elections slated to be held next week, has proposed an unorthodox idea to combat his country’s rampaging 138% annual inflation rate: dollarizing the economy.

Dollarization, a colloquial term to refer to the adoption of the USD as legal tender, by substituting the Argentine Peso with the USD, comes across as a common-sense solution to snuff out hyperinflation. By substituting its beleaguered domestic currency with the USD and shutting down the country’s central bank (ostensibly to prevent it from cranking out reams of domestic currency to finance the country’s ever-yawning fiscal deficits), Argentina hopes to arrest the death spiral of its domestic currency (the Argentine Peso sunk to a new low of 1000+ Vs. The USD a couple of days ago).

This [substitution] is, in effect, expected to break the back of hyperinflation immediately since a full substitution completely eliminates the risk of depreciation to the local currency.

Argentina wouldn’t be the first country to attempt a dollarization…

Ecuador, El Salvador and Panama are some examples of countries that have adopted the USD as legal tender in the past. In the current era, Zimbabwe’s move to dollarize (after hyperinflation tipped past a daily rate of 100% in late 2008) met with some success with inflation averaging about 43% from 2009 until 2023.

… but as a $632 billion economy, it will be the largest Emerging Market to attempt it yet.

For a country that’s now developed an iron-clad reputation as a serial-defaulter on Foreign Currency Debt, is currently the largest debtor to the IMF and which, in 2002, due to its weak fiscal discipline, had (prematurely?) pulled the plug on its currency board regime, there appears to be little choice now but to adopt the USD as new legal tender.

The Argentine attempt to dollarize piques the curiosity of any EM Debt investor, especially when viewed in the context of Argentina’s size as the second largest economy in South America.

When asked, in 1939, about the role that the Soviet Union might play in the second world war, Churchill replied: “It’s a riddle, wrapped in a mystery, inside an enigma”.

That was his best attempt to describe a situation he found difficult to comprehend.

You may well use the very same words to describe the Argentinian plan to dollarize its economy.

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All fiscal policy decisions are determined by the Congress and the White House; the Fed plays no role there. Its remit is the Monetary Policy.

This often creates a conundrum for the Central Bank: how does it then really tackle inflationary headwinds that are offshoots of a loose Fiscal Policy?

There are many examples of US fiscal profligacy from the recent past: the Trump tax cuts of 2017 (the tax cuts were supposedly funded but turns out they were mostly financed by federal borrowing); the roughly $5 trillion dollar in pandemic stimulus money aka Helicopter Money; the $1.2 trillion spending infrastructure bill that Biden signed into law in 2021; and the $433 billion investment in the Inflation Reduction Act, 2022 (offers households rebates and incentives of up to $28,500 to install climate friendly household appliances and switch to electric cars)

Guess who pays for those government spends/rebates/subsidies/tax incentives?

Well, they ought to be supported by tax revenues but if the tax revenues come in lower than the spends, then you have a problem.

This is where the US Treasury steps in, issues USTs, and saves the day for the Government.

But what if the federal government does not rein in spending? What then?

Enter ‘The Bond Vigilantes’!

A Bond Vigilante (a word coined by Edward Yardeni) refers to a bond market investor who protests against monetary or fiscal policies considered inflationary by selling bonds, thus increasing yields.

The events that whipsawed the bond markets over the last few days have led to whispers that the Bond Vigilantes are back and are hemming in the US Treasury (in a close parallel to how the Gilt Markets torpedoed former UK chancellor Kwarteng’s GBP 45b package of unfunded tax cuts at about the same time last year).

The Fed Rate is an effective tool for determining monetary policy and reining in inflation, but the Bond Markets can bring things to a boil faster if they decide to play ‘activists en masse’ (Opinions vary with Bill Gross indicating, in a recent interview, that Bond Vigilantes will have a muted effect).

The ramifications in the bond markets play out across a much larger scale around the planet involving Banks, Insurance companies, Pension Funds, Corporate and Sovereign Debt Markets.

Insurance and Pension Funds buy bonds to hold them until maturity, but those portfolios may be upended in a situation where the Bond Vigilantes sell ahead of the pension funds, leaving the funds no choice but to sell out as well to meet collateral calls (These are the very sequence of events that played out in the UK last year when the yields on Gilts soared momentarily).

The events over the last few days have played out against the backdrop of a net treasury issuance in 2023 that is the second highest on record (after the pandemic) and in an environment where the biggest buyer of T-bonds, the Fed, has stepped back from the market as it continues its tightening program.

Something has to give!

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Microsoft fired the first shot in the Generative AI arms race when, earlier this year in January, it announced a $10 billion investment in the Chat GPT parent, Open AI. Alphabet Inc. followed suit with Bard; Amazon announced Bedrock. And Apple has been relatively quiet.

Yet, the investment in Open AI isn’t Microsoft’s most significant one in recent times. That investment pales in comparison to Microsoft’s $69 billion acquisition of Activision Blizzard announced in early 2022.

The Microsoft-Activision Blizzard deal, after regular skirmishes with anti-trust regulators in the US, UK and the EU now appears to be on the verge of completion.

Microsoft has long been criticised for its inability to create iconic consumer products (and remains comfortable in its traditional mould of an enterprise technology company).

Funny but true: Xbox is the only pure-play consumer-focused business that Microsoft has!

Microsoft has done well to integrate LinkedIn and GitHub; but the Activision Blizzard acquisition could be its toughest integration act yet.

The deal is pricey, yes, (the acquisition price is about 8x Activision’s 2021 revenues) but Microsoft’s real challenge would be to make Activision’s blockbuster games Candy Crush and Call of Duty available on all screens, including Mobile Screens.

This creates Microsoft’s biggest challenge in this acquisition: the mobile screens are cornered by the Apple – Alphabet duopoly (through the Apple Store and Android Playstore).

This leaves the ‘Enterprise Technology Specialist’ with no choice but to try and build an app store for games on iPhone and Android smartphones.

That App Store from Microsoft, expected to be launched in March 2024, has a lot riding on it!

It’s the key to the successful integration of what is the largest tech acquisitions in recent times.

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Avinash Menon, CFA

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