person wearing mask outside by a car.

Weekly Market Comment: June 1, 2020

Signs of economic hope emerge with the start of summer

Confidence and optimism is powerful and investors seem to be ignoring a lot of negatives, focusing instead on the positives such as shops re-opening and the public emerging from their homes at levels not seen since the lock-downs began. For example, our local coffee shop had eight people sitting in it, a sight we haven’t seen in months.

U.S. mortgage applications have recovered and hit a new high (though the number of homes sold remains depressed), same-store sales are starting to show some life, and hotel occupancy troughed in the low 20% range, now in the low 30% range. Manufacturing new orders expectations have bounced materially and are no longer contracting (though capital expenditures by companies remains understandably low). Bank of America’s CEO predicts a ‘fairly rapid recovery’ while even the economist Paul Krugman is optimistic.

And then you have the EU attempting to enact a near $2 trillion stimulus deal for the Eurozone, though they have not yet reached consensus on a plan. The level of monetary and fiscal policy help is unprecedented.

China/U.S. relations still refuse to wear a mask

Last year, China tried and failed to have the mayor of Hong Kong give up more control her city to China. That attempt sparked the now famous protests we all heard about, causing the mayor (and the mainland Chinese government) to back off their proposal.

Having failed, China is now attempting a more bold and direct assertion of control of Hong Kong by enacting a security law that would effectively make any anti-Beijing sentiment illegal. As tensions resume on the ground in Hong Kong, America declared Hong Kong no longer autonomous from China and said it would end almost all aspects of the American government’s special relationship with Hong Kong, which includes trade and law enforcement.

Canada has joined the growing criticism of China’s encroachment over Hong Kong’s way of life. China continues to hold two Canadian businessmen in prison as the B.C. Supreme Court ruled against Huawei’s CFO who must remain in house arrest in Vancouver.

Whatever it all means, it’s clear that trade and political tensions between the two largest economics continues to rise. America is increasingly blaming China for negligently letting the coronavirus spread happen faster and wider than they should have. They are also contemplating kicking Chinese companies off of American stock exchanges.

The biggest and most obvious loser in the short-term will be Hong Kong itself, which did $66 billion worth of trade with America last year and would (if China has its way and takes control) lose its long-held reputation as a lawful, open society, and global financial hub.

What does U.S. shale oil and musical chairs have in common?

One of the hardest hit sectors (and one we have not owned in a long time) has been the U.S. shale producers. According to the Wall Street Journal, the large publically traded ones spent a collective $1.18 trillion to drill and pump oil over the last decade. What did they get in return for their investment? Only $819 billion. American energy independence sounds nice but what is the point if it requires tax payer, equity and bond investor cash injections to subsidize it all?

Here's roughly how it works. A shale company raises capital from investors and spends it drilling, usually horizontal fracking. Their production and reserves rise, pushing up the stock price. But what doesn’t rise is their cash in the bank because they have more expenses than they do sales. So, with the stock price higher, they issue more equity and/or bonds and pull in more money from investors (who are happy because production is rising). The cycle gets repeated. Oh, and company insiders sell some stock along the way because they all have families to look after and golf courses to live next to.

But eventually the negative cash flows gets noticed by the stock market and sends the shares down. Or maybe the price of oil plummets because of COVID-19 and the Saudis announce they will increase the world’s supply, making an already bad situation worse.

When the music is playing, everybody is having fun. But when the music stops – as it tends to do around recessions – a lot of oil investors lose money under the crush of debt, chronic cash-flow imbalances, and panic selling.

Savvy investors look to pick up the pieces after a crash. But they will also know that U.S. shale is not a sustainable, long-term, buy-and-hold investment.

Crude oil chart.

Notable reads:

Musings Beyond The Markets

Shakespeare’s Sonnet 18 compares a young person to a summer’s day.

Portrait of William Shakespear

“Shall I compare the to a summer's day?Thou art more lovely and more temperate:Rough winds do shake the darling buds of May,And summer's lease hath all too short a date:Sometimes too hot the eye of heaven shines,And too often is his gold complexion dimm'd:And every fair from fair sometimes declines,By chance or natures changing course untrimm'd;By thy eternal summer shall not fade,Nor lose possession of that fair thou owest;Nor shall Death brag thou wander'st in his shade,When in eternal lines to time thou growest:So long as men can breathe or eyes can see,So long lives this and this gives life to thee.”

The TSX Composite gained 1.9% as the S&P 500 rose 3%.