It’s time to start building exposure to risk assets

Back in late October, I published a note entitled “It’s Time to be Neutral or Short Risk”

I now think that current market levels and conditions warrant getting long. My reasoning is as follows:

Oil prices have been a major driver for other assets, primarily via second round effects. So let’s start there.

First, speculative positions in Oil are now very low, back to 2009 levels:

Second, the ~26 level on oil is a very long term support resistance level that stretches back several decades:

Third, $20 or so is the current cash cost of producing shale oil, which means that even if prices get there, they are unlikely to be at that level for long. As such, this means downside is capped.

Finally, Oil has had a seasonal tendency to bottom around now:

In addition, investment grade credit, which lead the way lower, has been broadly stable on an outright yield basis, though spreads have widened as risk free yields have fallen.

In high yield space, the spread (Barclay’s HY OAS below) has hit levels not far from the very worst levels of 2011:

The fundamentals for the economy also remain decent, though not robust. Earnings ex-energy are still growing. Employment is still growing, though likely to slow a bit in the months ahead. Retail sales still strong. Credit conditions easy. Even in China, the policy easing we’ve seen over the past 4 months will start to bear fruit soon – allowing for at least some stabilization in the data. The Philly Fed has bounced, which suggests that ISM manufacturing could do the same:

It is also worth noting that while the negative effects of lower oil prices are front loaded, the positive effects play out over a longer period of time. Per FTA, current oil expenditures as a percentage of world GDP has dropped at a pace not seen since the mid 1980’s:

Back then, world GDP in USD terms subsequently rose strongly over the next 5 years:

Here is a related chart from Deustche Bank:

Fear, as proxied by cash levels from the BAML survey, are already as high as highs from 2011 / 2012:

And the price action has been bad enough to have triggered technical selling on the breach below the ~1880 area. But note that a break below, followed by a rally above the close would bring a lot of chart driven short covering. The break has probably been bad enough to flush out most of the remaining ‘weak hands.’

Supporting that hypothesis is the fact that futures volume yesterday was about ~4mm contracts, a level that has historically coincided with near term lows:

The bottom will take some time to form. Volatility will need to fall to bring buyers back in. But I do believe that we are at the beginning of the end rather than the end of the beginning.

In interest rates space, investor expectations are now very gloomy indeed. Citi distributed a survey yesterday to its rates clients, and reported that 3/4th of respondents expect a terminal Fed Funds rate at or below 1% this cycle. (!) A stabilization (and possible bounce) in oil and associate risk assets, in conjunction with improving data, will allow inflation breakevens to reprice substantially. In the inflation swap market, 5y5y forward inflation is through the 2008 lows: (caveats apply given the market, but the point applies regardless. 30 TIPS breakevens are ate 1.5%)


14 thoughts on “It’s time to start building exposure to risk assets

  1. Your post made me so mad!!! I wish I had found this site earlier and really loaded up UWTI yesterday! Damn! Damn! I thought UWTI would drop to $1, if not lower yesterday… with so many pundits calling for $10/barrel oil! By the way, I love your post!

  2. Nice post, but it seems your rational for a rally is that oil price have bottomed. While that might be true, there is still lots of supply and market share war with OPEC. I’m not saying oil is over valued at $30, it certainly isnt, but the market dynamics are such that prices may still go lower as US production is forced off line in an uneven fashion

    To be more constructive, IMO, I would want to see small caps rally and the Yen stop appreciating.

    From GS, who is pretty good on oil, imo

    Despite yesterday’s relief rally, market perception continues to be that demand fears have driven the oil market and other financial markets lower. We stand by our view that recent price declines are not demand driven but rather driven by structural supply forces that have created violent moves to the downside as the market enters the inflection phase to create a path towards a new equilibrium. The oil market is simply not pricing like a demand-driven bear market. Timespreads in Brent and oil products have strengthened, not weakened, and weakening timespreads are characteristic of demand-driven price declines. Further, some end-use oil product timespreads have tightened more quickly than crude oil timepreads. Demand weakness would have generated the opposite result, and refining margins also remain far above recessionary levels, with some product margins like gasoline actually strengthening on both a relative and absolute basis

    1. Hi abee, thanks for commenting!
      Yes, GS has made some very good calls on oil the past couple years… it is interesting that they said earlier this week that they think oil is more likely to be at 40 in Q1 rather than 20.

      I don’t think oil is the only reason for a rally, though a major one. I do think, however, that negative momentum in oil prices was a key reason people were not willing to buy risk. As a result, I didn’t think that oil prices needed to rally for risk assets to rally. Rather, a stabilization was sufficient…

  3. Your previous post about being short risk was great. The last one, even if currently it is proving right, is less obvious to me. The motivations are poorer this time. So I stay with those that say that the market will make another 10% leg down. Even if oil stabilizes, we will get deflation. Combine this with China slowdown and with HY spreads and you will get a perfect storm.

    1. I certainly can’t rule out another 10% move lower from here, but I guess I have a hard time imagining a plausible scenario where that happens, at least in the near term. A major Fed policy mistake, and/or substantial weakness in the labor market would be required, I think. My opinion is that the oil, China, HY, deflation stories are broadly in the price already, in many cases with a premium. HY spreads ex-energy, for example, are well in excess of what likely default losses will be given this macro backdrop. 30y Inflation breakevens at 1.5% discounts a significant miss by the Fed vs its inflation mandate. That certainly doesn’t mean things can go further, but my opinion is that the risk premiums in the price are getting attractive enough to fade, given the risks. But I certainly agree that there are risks aplenty!

  4. Got a question regarding oil,,,

    According to the Weekly Petroleum Status Report current crude oil inventories are currently standing at 486.5m barrels (as of Jan 15, 2016).

    On the other hand, storage capacity (see Working and Net Available Shell Storage Capacity) is around 551m barrels (adding up capacity at refineries and crude tank farms).

    So everything else being equal those tanks should be full in 2 to 3 months time. There is other capacity, of course, tankers and the like, but this involves higher costs which makes it less attractive. Once you run out of storage capacity prices should drop even further since it doesn’t make economic sense to produce even more (refineries can pick up the slack but this brngs us back to the same problem after a while).

    So why shouldn’t prices drop even further, at least in the medium term, until enough producers went bust, taking their debt with them (which imo is the main reason to keep on pumping)?

    Just wondering…

    1. Hi Eddie, as far as I know, most analyst do not expect a complete usage of storage. Crude storage is seasonal, due to seasonal changes in supply and demand. In addition, there should be more storage being built out given the high costs.
      Even if storage is filled, prices should only fall to cash costs, because it doesn’t make sense for the producers to continue pumping oil if the sale price is less than the costs of labor, electricity, transport, insurance, etc etc. As I mentioned in my post, that is in the $20 a barrel area on average, depending on the producer, well, etc.
      Current prices are already below cash production costs for many producers, though many are still producing due to the fact that they have hedged. Once the hedges roll off, the production will fall if prices remain at current levels, regardless of if the producers go bust then (as is likely) or not.

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