Here are the top market developments on our radar.
1. The global shipping network is engulfed in a crisis. Resolving the crisis and ensuring a more resilient network is crucial to the easing of inflationary pressures.
In the US, the crisis is most visible in San Pedro Bay, home of the Port of Los Angeles and the Port of Long Beach, which together comprise the ninth largest port system in the world. In late September, a record 73 cargo ships, holding approximately half a million containers, were idled off shore. The photograph below from MarineTraffic shows the congestion.
Source: MarineTraffic. This photograph shows the marine traffic, based on satellite imagery, near the Ports of Los Angeles and Long Beach. The green icons represent cargo ships.
Over the last few decades, globalization and the associated increase in global trade were facilitated by the shipping industry. The global shipping system became more complex with the advent of just-in-time inventory, more consolidated to offset low profit margins, and more reticent about expanding physical capacity in a world enamored with capital light businesses. Recently, government policy reversals due to COVID-19 outbreaks and ongoing geo-political tensions added to the caution about expanding capacity.
The pandemic wrecked havoc with the existing system. The large decrease in economic activity in early 2020 left the system even more unprepared for the subsequent massive increase in demand for goods as economic activity resumed. The demand for goods outstripped pre-pandemic levels as limits on the ability of services, including travel, indoor leisure activities and restaurants, redirected consumer spending towards goods. In the US, the shift in consumer spending preferences has been so big it has led to a staggering $26 billion increase in the monthly trade deficit for goods compared to pre-pandemic, as shown in the chart below. The monthly trade balance for goods is currently hovering around a record -$90 billion, as the trillions of dollars of US fiscal stimulus have been directed to purchasing goods from overseas.
![Source: U.S. Census Bureau and U.S. Bureau of Economic Analysis, Trade Balance: Goods, Balance of Payments Basis [BOPGTB], retrieved from FRED, Federal Reserve Bank of St. Louis.](https://images.squarespace-cdn.com/content/v1/5c454f2c4cde7a1a753c3e95/1633481762745-NZUFTLK66SPEVUS69LLG/fredgraph+%284%29.png)
Source: U.S. Census Bureau and U.S. Bureau of Economic Analysis, Trade Balance: Goods, Balance of Payments Basis [BOPGTB], retrieved from FRED, Federal Reserve Bank of St. Louis.
The global shipping system, with its complexity, lack of excess capacity, and focus on economies of scale, was not flexible enough to quickly adapt to such a big shock. When export volumes cannot be moved quick enough, intermediate goods cannot reach processors in a timely fashion, and businesses are fighting to get container spots on available ships, the result is shortages and price increases to ration supply. It will take considerable time for the system to find a new equilibrium, even if the demand for goods moderates.
2. Soaring energy price are not only adding to inflationary pressures, but are currently testing the resilience of the recently redesigned system for energy generation and transmission in Europe.
In September, the price of WTI crude oil rose 9.5%, while the price of natural gas in the US soared 34%. In Europe, the price of natural gas spiked to an all time high and is now triple the price level in the US.
The large rise in energy prices since last summer, as shown in the two charts below, was not initially concerning. It was the result of the boom in economic activity as national and state governments eased economic restrictions post the peak of the pandemic.
The problem is energy prices have not stopped rising as economic growth has moderated. The reason? Supply. In recent years, oil companies have dramatically scaled back capital spending. The transition to renewable energy has gained steam, the companies have been demonized as contributing to climate change, and the equity market has punished the companies for a focus on growth. Finally, the market share war in early 2016 scarred all oil producers, whether government owned or shareholder owned, as oil prices plunged.
The pick-up in economic activity pushed oil demand well above oil supply. With essential commodities that have no readily available substitutes, small shifts in demand or supply in a finely balanced market can lead to sudden large price changes. While we anticipate oil prices to remain high, the problem may not be as intractable as that facing the global shipping system. With oil, the cure for high prices tends to be high prices, as it will moderate demand and incentive additional supply.
Natural gas prices in the US will also moderate as domestic supply increases. However, Europe is not as fortunate. The European natural gas market is fragmented as shown in the chart below. Europe has less indigenous supply. It is dependent on imports via natural gas pipelines from non-European countries and on LNG (liquified natural gas) from the overseas, particularly from the US.
Europe is further down the road in transitioning to renewable energy and has disincentivized coal and nuclear energy. When the demand for electricity generation accelerated with economic activity, demand for natural gas skyrocketed because it is the marginal energy source for baseload electric power. Europe did not have sufficient long term, fixed price natural gas contracts in place, so it is subject to paying the skyrocketing prices in the spot market. Lastly, geo-politics has been an impediment to Europe reaching supply agreements with Russia, one of the world’s biggest sources of natural gas. The soaring natural gas prices will be a huge headwind to European industrial activity and may cut into consumer spending. The European electricity generation market has proven fragile.
3. The reemergence of credit risk has been a concern of ours. The debt crisis at Evergrande will test the resiliency of China’s financial system and economic model.
Evergrande Group, a Chinese conglomerate, is one of China’s largest property developers. In September, it missed coupon payments on two USD bond tranches. With more than $300 billion in liabilities, including nearly $20 billion in offshore debt, its upcoming debt restructuring has tightened financial conditions in the property sector, much of which is also debt-laden. It is estimated that the property sector accounts for almost 30% of China’s GDP.
The conglomerate employs about 200,000 people and is estimated to indirectly sustain almost 3.5 million jobs via business relationships with around 8,000 upstream and downstream companies. The People's Bank of China was forced to make multiple large injections of cash via reverse repos into the financial system to support the interbank lending market.
The near term challenge for the Chinese government will be to manage an orderly unwind of the conglomerate whose demise creates risk to banks with loans to the conglomerate and broader property sector, wealth management companies with real estate linked products, materials companies dependent on real estate development, and local governments dependent on real estate sales tax revenues.
In recent years, Chinese economic growth has been heavily dependent on debt financing. The longer term challenge will reduce the dependency on debt financing while transitioning the economy to more services and lightening the dependency on property development and manufacturing exports.
4. Global equity markets sold off in September. The bull market will get a test in coming months if the Federal Reserve decides to taper its purchases of Treasuries and agency mortgage backed securities.
In the most recent FOMC statement, Chairman Jerome Powell indicated tapering “may soon be warranted.” Recent history tells us the Federal Reserve will almost always err on the side of caution when it comes to tightening financial conditions and will not hesitate to loosen financial when the economy or stock market has a big wobble. With real economic growth moderating, higher inflation still persisting, stocks at high valuations relative to history, and equity sentiment bullish, a tightening of financial conditions could serve as another test of the equity bull market.
This chart shows the performance of the S&P 500 Index (SPX) in blue, the iShares Core MSCI Europe ETF (IEUR) in green, and the iShares MSCI China ETF (MCHI) in orange.
Note:
At Two Centuries Investments, we seek high investment returns and alpha, but also seek to design investment strategies that are resilient. We willingly accept return volatility but seek to reduce the probability of large underperformance and mitigate market crashes. One of our other goals is reliable investment strategies. We acknowledge our portfolios will periodically underperform, but we want to prevent investors from panicking and taking drastic actions inconsistent with their long-term financial plans. We believe resilience is underappreciated in investments and many other aspects of life.