The Weekend Edition # 130 - The Reflation Trade brings Opportunities

Welcome to another issue of the Weekend Edition!

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Here's what we cover

• Market Recap - Fear and Uncertainty

• Macro - The Reflation Trade Brings Opportunities

• Earnings Season - Banks have a rocky start

• Closing Thoughts - The Fed’s Botched Landing?

• Calendars

Market Recap - Fear and Uncertainty

April 08 - April 12, 2024

It’s been a tough week. Downside price action brought about by macro data was magnified by fear of geopolitical tensions. The market was not prepared for it.

For months we have seen extreme positioning only on the long side of the trade with very little hedging for unforeseen outcomes. The market had become complacent about further escalation in the Middle East.

Friday brought all that fear back. Not only did the equity markets have one of the worst days since October 2023 but, we saw a bid in bonds, gold and oil - all brought on by the risk of war between Iran and Israel, with the possibility of the US stepping in.

People buy bonds and gold when they are scared. They are a safe haven and consequently the US Dollar also gets a bid, not just because of the demand for buying bonds but as well because the USD is also a safe haven.

But, the strength in the US Dollar didn’t start on Friday. We’ve had this pressure on markets with the slew of Fed speakers parading their hawkish narrative and with Wednesday’s hotter-than-expected CPI number, the market priced out one full rate cut from the Fed.

The market now expected 2 cuts instead of 3 and possibly starting in September, not even July. By some measure, “supercore” inflation is averaging at 8% for the last three months - this is services inflation less energy, rent, and OER.

We’re at a critical level for the S&P 500. We’ve broken below a key level and on a technical basis, we’re approaching the 50-day moving average. We need this level to hold or it could start to get ugly. If this market sees a proper correction, we could have further down to go. We’re not saying the market will go straight down, but it could be prudent to put some hedges in place for a decline over the next few weeks.

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Macro - The Reflation Trade Brings Opportunities

One of our major concerns about this rally was that a strong economy and a resurgence of inflation could push up long-term yields, putting pressure on the market. This is exactly what we’re seeing play out right now.

Three months of hot inflation data and now the market is seeing this as a trend. This shouldn’t have come as a surprise. We’ve been seeing commodity prices increase from February and the Fed’s dovishness has led to financial conditions that are easier than when they started hiking.

We see inflation remaining higher for longer here because:

• Global Uncertainty and poor Weather Patterns will keep Commodity Prices higher

• The Late Cycle US Government Stimulus to win the election

• Manufacturing Picking Up and a new Credit Cycle on rate cut “hopes”

However, if anything this reflationary situation could yield interesting opportunities in US equities and that’s something we have been progressively positioning for.

We’ve liked Energy and Industrials and have started to add Materials and Mining to capture the upside, given these sectors still have room for upward EPS revisions and remain undervalued compared to a very expensive S&P500.

We have a few interesting ideas that benefit from the reflation trade:

Schlumberger (SLB)

• SLB is an oil and gas services company pivoting to digital services for the industry. It has room for growth even without the boost from oil prices. This would be a good buy & hold.

• Room to grow in digital products given the industry is still largely analog and there isn't much competition.

• The company is a Beneficiary of capex spending by international oil producers with expected revenue growth of 10-12% in 2024, margin expansion, and strong FCF generation.

Freeport-McMoRan (FCX)

• There is a deficit in copper supply and with the manufacturing cycle picking up, the demand for copper will put upward pressure on prices.

• FCX is one of the largest copper miners and has long-term projects in place to add 400 million pounds of copper without much incremental investment in the next 2-3 years.

• New breakthroughs in technology have helped FCX extract more copper from existing low-grade mines.

• The company forecasts an EBITDA of $10B based on $4/lb for copper and $14B, if copper hits $5/lb. Operating cash flows under these price scenarios range from $7 billion to over $10 billion.

Vital Energy (VTLE)

• A slightly riskier oil and gas play that we sent to premium clients a few weeks ago. An undervalued opportunity trading below book value with solid ROE metrics.

• The company is committed to becoming free cash flow positive and reducing their debt levels in 2024.

• Higher oil prices will definitely help increase margins and improve cash generation.

Wheaton Precious Metals (WPM)

• Wheaton Precious Metals is a streaming company that focuses primarily on gold, silver, and other precious metals. They provide financing to mining companies. In return, they receive the right to purchase a portion of the mined metals at a low, fixed cost. They then sell these metals, often at higher market prices. This business model allows them to benefit from the production and sale of precious metals without bearing the costs and risks associated with operating mines.

• Earnings are highly sensitive to the upside in commodity prices.

• WPM has increased their portfolio globally which provides diversification and is seeing expansion of their existing miners with increasing levels of production.

Earnings Season - Banks have a rocky start

We started earnings season with the Banks and BlackRock this Friday. The headlines for BlackRock read:

“BlackRock Hits $10.5 Trillion Asset Record with Bond Inflows”

The inflow for the first quarter was $76 billion net, of which $67B gross went to ETFs and $42B gross went to Fixed Income Funds. Quite interesting given that we’ve been seeing bond prices fall in the first quarter of the year, and it seemed like people are shying away from bonds.

But, bonds have always been a vehicle for earning income and this is the best time to lock in that “fixed income”. I doubt most of these people are looking at it as a trade.

While bonds are certainly a safe haven, and great income vehicle, we can’t justify buying long term bonds here because there’s just not enough term premium to make it worthwhile. Shorter term bills have far better returns right now.

On the other hand, banks didn’t have the best start. A few quarters ago, Jamie Dimon, the CEO of JPM talked about how banks were over-earning on tehir net interest margins (Interest earned on Loans to Clients less Interest paid on Deposits from clients). Well, the time has come for that to materialize. The banks reported sequential declines in the Net Interest Margins and the forecast is for this to get worse. JPM also forecasted higher expenses.

One comment that caught my attention was: “Consumer balances are normalizing”. It would seem much of the excess savings are now gone. Another was that deposit migrations have not changed. Deposit migrations are when people put money into fixed deposits from checking accounts. And finally, consumer banking actually saw a slowdown in loan growth.

While JP Morgan continues to tout the consumer as being “strong”, these are signs that there is a slowdown in spending, mainly because the “excess wealth” is not in excess anymore.

The bright spot, however, is that despite these declines the banks are earning enough money to have a stable capital base and return funds to shareholders.

Closing Thoughts - The Fed’s Botched Landing?

At the beginning of the year, this was an issue that we feared - a re-acceleration of inflation brought on by the Fed’s dovishness at the end of 2023. We talked about how animal spirits would take over and a new credit cycle would begin, as the Fed’s talk of rate cuts made financial conditions easier.

The escalation in geopolitical tensions, and the shortage of agricultural commodities due to El Nino weather issues, and we’re seeing headline and core inflation starting to move in the opposite direction.

While Fed Chair Powell said at an International Monetary Fund event last year that "the biggest mistake we could make is really, to fail to get inflation under control", they don’t seem to be living by that view anymore.

The Fed has increased its inflation forecast for the year and is still talking about easing. As far as they are concerned, it would seem they find it acceptable to live with a higher than 2% level of inflation this year.

The Fed has its back against the wall here. We’ve talked about the interest cost on US debt time and time again, as probably the biggest reason for the Fed to cut rates. Plus, we’re coming up on the four-year mark of refinancing Corporate America’s debt at a lower level of interest rates.

The truth, however, is that if the Fed starts to cut too soon and into inflation that is accelerating, we will see inflation blow up. It would be, yet again, a policy mistake.

It’s sad because this time, the Fed actually came pretty close to pulling off a relatively smooth hiking cycle. What they do from here, could result in a botched landing!

Have a great week ahead!

Sincerely yours,

Ayesha Tariq, CFA

There’s always a story behind the numbers.

Calendars

US Earnings Calendar

US Economic Calendar in Eastern Time (Source: Trading Economics)

None of the above is Investment Advice. I may or may not have positions in any of the stocks or asset classes mentioned. I have no affiliation with any of the companies other than explicitly mentioned.