Topics: A revised map of the United States; investing in equities before a recession; Russia’s natural gas squeeze on Europe leads to another rescue program for Italy; the high cost of pariah status for the oil refining industry
Independence Days. Europe’s energy crisis, China’s commodity trade war with Australia and other examples of resource nationalism (India and Indonesia restrictions on exports of wheat, sugar and palm oil) all reinforce the following: reliance on food and energy imports creates supply, price, currency stability and national security risks. In the US, food and energy imports as a percentage of consumption are the lowest out of all manufactured goods categories, resulting in a degree of food and energy independence uncommon to other countries.
This prompted me to create a map of the United States in which each state is sized based on its production of food, energy and minerals. I used 2021 production values; had I used 2022 data, the results would be more amplified. The results: states in the Northeast, Southeast and Pacific Northwest shrink relative to mid-Western and mid-Atlantic states, and Texas. As the Biden administration evaluates options to reduce the highest US food and energy inflation in decades (overtures to Saudi Arabia and Venezuela for more oil; a ban on export of US refined products1; gas tax holiday; increase from 10% to 15% in summertime ethanol blends to boost gasoline supply but which has driven corn prices to all-time highs - see Appendix I and II), I think about this map a lot2.
- Energy includes crude oil, natural gas and coal, plus electricity generated by nuclear, solar, wind, hydro, geo-thermal and biomass
- Non-fuel mining includes metallic metals (cobalt, copper, iron ore, REE, nickel, platinum, palladium, zinc), construction aggregates (gravel, crushed stone, construction sand) and other industrial minerals (gypsum, lithium, peat, potash etc)
- Food includes gross receipts of farms (meat, dairy, poultry, fruits, vegetables, food/feed crops)
The US is a “Republic” which ascribes electoral and legislative power to some states in this revised map that is in excess of their population shares. Their critical contributions to food and energy independence are often underappreciated by an increasingly urbanized society (see below on the energy disaster now facing Germany), so I generally believe that a Republic ends up in the “right” place. But I also know that it’s a difficult time to have that discussion. There are different kinds of independence; while US energy independence has finally been attained, other kinds of US independence are suddenly disappearing. They are outside the scope of this report; I will refer you instead to press articles on JP Morgan’s policies with respect to its employees and their reproductive rights and health3.
In any case, food and energy inflation and independence also bring to mind another chart below. The unwinding of the largest stimulus program in history has resulted in a repricing of “real world” vs “digital world” assets, with the former comprised of equities linked to the food, energy and mining products used to build the US state map. The repricing of “digital world” stocks has resulted in more reasonable growth stock valuations for the first time in a while, and is part of the “investing before a recession” topic we discuss next.
Line chart shows the energy dependence and independence of Europe, China, US and Russia through comparing net imports of oil, natural gas and coal in million tonnes of oil equivalent. The chart shows that recently the US hasbecome energy independent, while China and Europe continue to be high importers of fossil fuels. Russia remains a net exporter.
Line chart compares the performance of energy, food and mining companies to the performance of companies predominantly within the digital space since June 2019. The chart illustrates the outperformance of the energy, food and mining companies, or “real world” assets, over the last few months.
Digital world: ride sharing, digital payments, cybersecurity, cloud computing, big data, social media, fintech, metaverse, food delivery, online shopping, wearable tech, peer-to-peer video, gaming, commission-free trading, video streaming and crypto
Lessons learned on energy independence: Germany
Germany, aiming for 100% renewable power by 2035, is now pushing the G7 to rescind a commitment to halt financing of overseas fossil fuel projects. Instead, Germany wants the G7 to “acknowledge that publicly supported investment in the gas sector is necessary as a temporary response to the current energy crisis”. Why? For the first time since the war began, Russia is cutting gas supplies to Europe via the Nord Stream pipeline (see supporting chart below), leaving Germany with only 10 weeks of supply. The risks: damage to Germany’s industrial furnaces requiring 75% gas inputs, gas rationing to homes and businesses, an exodus of manufacturing jobs and a steeper recession. One vital choke point: the world’s largest integrated chemical complex run by BASF which sits at the beginning of many industrial supply chains, including ammonia for fertilizer. BASF Chief Executive Martin Brudermüller: “There is no short term solution to replace natural gas from Russia”.
A postscript: Eastern Europe, long wary of relying on Russian gas and ridiculed as paranoid by Germany, is moving forward with plans to source nuclear technology from the US. These countries might have sourced it from Germany had the country not sold its nuclear technology assets to Russia’s Rosatom during the Merkel administration.
Sources: Bloomberg, Wall Street Journal, Foreign Policy Magazine, JPMAM.
Investing in equities before a recession
I don’t know if there will be a recession in the US, but chances are rising so let’s assume there will be. In the last Eye on the Market, we discussed how equity markets usually bottom before recessions and how equity markets were already rising by the time the recession was underway (see table below which summarizes the results). If that’s the case, investors need to be on the lookout for signals that are not as stale as employment and GDP. Historically, PMI surveys have been the best leading indicators. We expect these surveys to continue falling, but will be watching closely for turning points.
Another equity market signal: in past cycles, equity markets did not bottom until long term Treasury yields were declining, or at least until they stopped rising. The first chart below shows 10 year Treasury yields; the vertical bars represent equity market bottoms. In the last three cycles, bond yields started falling well before the equity bottom. From 1950 to 1982 when rates were rising on a secular basis, Treasury rates hit their peak right at the equity bottom. So, while I’m not a technician, a sign that the PMI index has bottomed out and that Treasury yields have peaked would be a good sign for investors, even as economic data are still deteriorating.
Line chart shows the 10 year Treasury yield and vertical bars representing S&P 500 Index bottoms since 1950. The chart illustrates that bond yields often peaked prior or right at equity market bottoms.
Line chart compares the Global Manufacturing PMI survey to the 10 year Treasury yield. The chart illustrates that manufacturing activity is declining while the 10 year Treasury yield has been increasing since late-2020.
Meanwhile, market signals on investor capitulation are mixed. As shown on the left, there has been a spike in the number of companies trading below the value of cash on their balance sheets. To be clear, companies that are destined for insolvency can trade below cash value for good reason (i.e., when the value of their non-cash assets are insufficient to repay liabilities). But as a measure of capitulation, this is a sign that investors have thrown in the towel on many of their ill-fated growth investments. In contrast, the chart on the right shows a survey of retail investor asset allocation preferences (which are still elevated) vs consumer sentiment (which has crashed). The growing gap between the two suggests that retail investors are still too optimistic.
I put more stock in the first chart (i.e., more capitulation) when combined with (a) data we discussed last time on how the average stock in the Russell 1000 Growth Index, the NASDAQ and the Russell 2000 Small Cap Index is down 40%-50% from peak levels, and (b) a sharp decline in hedge fund and risk parity fund leverage4.
Line chart shows the percent of stocks trading below the value of cash and short term investments on their balance sheets since 1990. The chart illustrates that 12% of companies are trading below their cash, with many investors having transitioned away from various growth investments.
Line chart compares the Michigan Consumer Sentiment Index to AAII equity asset allocation since 1990. The chart illustrates that although consumer confidence has fallen to its lowest level (50.2) ever, many retail investors are optimistic and still prefer equities.
On a related note, I read an article in the Atlantic on the “end of the Millennial lifestyle subsidy”. The article notes that millennials have effectively been subsidized by overly optimistic investors and that this subsidy is now ending. Let’s assume that a prototypical millennial wakes up in a Casper bed, exercises on a Peloton, takes an Uber to their WeWork office, spends time on Snap while waiting for DoorDash to bring an Impossible Meat burger for lunch and takes Lyft home for a Blue Apron dinner. In aggregate, these companies were supported by equity investors despite having aggregate $6 to $10 billion in annual free cash flow deficits since 20185. Many of these companies will now have to be profitable to survive, which may involve higher prices to customers.
Bar chart shows the total annual free cash flow of various millennial companies from 2018 to 2021. The chart illustrates that since 2018, these companies have had roughly $6 to $10 billion in free cash flow deficits.
Line chart compares WeWork’s revenue, capital expenditures, cash from operations and free cash flow since 2019. The chart illustrates WeWork has improved their free cash flow deficit due to decreasing capital expenditures, rather than increasing revenue or cash flow from operations.
Russia’s natural gas squeeze on Europe indirectly leads to another rescue program for Italy
Inflation pressures are rising in Europe, in part since Russian supplies of natural gas to Europe are being cut again. For the first time since the war began, Russia cut gas flows to Europe through the Nord Stream pipeline: NS1 flows are down by 60% as Russia claims the need for turbine maintenance. Producer and consumer prices are rising in Germany at the fastest rate since 1980, and markets expect European headline inflation to hit 9% later this year which is ~2% higher than current ECB forecasts. As a reminder, natural gas shortages affect both energy and food prices since natural gas accounts for 70%-90% of nitrogenous fertilizer costs. As the ECB raises policy rates and credit spreads widen, this creates problems for one the world’s most indebted countries: Italy.
Area chart shows the amount of natural gas Russia exports to Europe via the Nord Stream 1, Ukraine, Yamal (Poland) and through LNG since January 2019. The chart shows exports have recently fallen significantly, primarily driven by Nord Stream 1 exports to Europe.
Line chart which shows both the German consumer price index and the producer price index since 1980. The chart illustrates that both series are rising at the fastest rate since 1980, the CPI is currently at about 8% and the PPI is approaching 35%.
I haven’t written about Italy for a while. Its default risk declined in 2012 when the ECB partially socialized Italy’s debt problem among other members of the Eurozone. Given Italy’s high sovereign debt, it needs low rates: as Gavekal Research has highlighted, every time Italy’s government bond yields drift above its economic growth rate (left chart), its debt ratio has gone up (right chart). Now yields are rising and growth is falling in Italy, threatening another surge in government debt.
However, it looks like yet another ECB rescue program is on the way. We expect an announcement in July; the ECB organized an emergency meeting when Italian 10 year yields hit 4% (~2.5% over Germany), which appears to be some kind of tolerance threshold. We expect the ECB to “sterilize” its purchases of Italian debt by soaking up money supply via European bank deposits, similar to the Fed’s repo program. As usual, the ECB hopes that the threat of intervention will be enough to drive Italian yields down without actually having to buy them. It should be obvious at this point that Italy is a permanent financial ward of the Eurozone, and that German savers who pay for this have effectively lost their economic independence.
Line chart which shows Italy’s 10 year government bond yield and the rolling 7 year nominal GDP growth. The chart illustrates how yields are rising to around 4% while GDP growth is falling to around 1%. This relationship suggests Italy’s debt ratio will go up.
Line chart which plots Italy’s debt to GDP ratio since 1992. The chart shows that the ratio has increased from less than 100% to above 150%. We also highlight three periods of rapid debt growth: Euro accession phase monetary tightening, Eurozone balance of payment crisis and the COVID stimulus programs.
Appendix I: US refining capacity, gasoline prices and the high cost of pariah status
- US refining capacity has been falling since COVID while US refined product consumption is back to pre-COVID levels
- US gasoline refinery shutdowns have increased due to (a) high maintenance/repair costs, (b) declining institutional investor interest in oil & gas, (c) declining bank lending to oil & gas, (d) widespread opposition to refinery expansion and (e) conversion of refineries to biofuels instead [Marathon, Phillips 66 and HollyFrontier]. Refinery shutdowns are very costly and practically impossible to reverse
- US refineries are operating at the upper end of historical capacity utilization
- Russia is the 2nd largest refined products exporter after the US, so sanctions affect global prices for refined products
- If US refining capacity continues to decline, options for eventually importing refined products are unfavorable
Line chart which plots US refining capacity and petroleum product consumption since 1985. The chart shows that while petroleum product consumption is back to pre-COVID levels, capacity has fallen from 19mm barrels per day to below 18mm barrels per day.
Bar chart which shows US refinery capacity shut down by year since 1990. The chart shows that there was a huge spike during COVID and approximately 1 million barrels per day of capacity was shut down between 2020 and 2021.
Line chart shows the utilization rate of US refineries since 1990. We include a dot for the latest utilization rate of 93.7% as of June 10, 2022. This represents the second highest utilization rate since the early 2000s.
Bar chart shows the top exporters of petroleum products in 2021. The US and Russia are the two largest exporters by a wide margin, exporting 140 million tonnes and 130 million tonnes respectively. The third largest exporter is Saudi Arabia with ~60 million tonnes and the rest of the top 10 export ~20 million tonnes each.
Line chart shows crude oil prices as refiner oil acquisition costs vs gasoline prices, which have both risen substantially in 2022
Line chart shows the US crack spread, which is the difference between refined oil product prices and refiner oil acquisition costs. Crack spreads have risen to all-time highs in 2022
Appendix II: energy/food independence and food price inflation
- The US has finally reached independence in both food and energy. Europe is also a net food exporter, but is still a substantial energy importer
- US farmers seeking to boost the food supply requested that the USDA relax rules related to the Conservation Reserve Program that pays them to keep land idle. So far, the USDA has only made minor adjustments, allowing farmers with CRP contracts expiring in 2022 to start planting now
- US corn prices are rising due to (a) an increase in US ethanol blends over the 2022 summer driving season, (b) the impact of rising natural gas prices on nitrogenous fertilizer costs and (c) a 25% decline in Russian fertilizer exports (Russia usually accounts for 15%-20% of global fertilizer exports, see bar chart). US tariffs on imported fertilizer have not been reduced; instead the Administration announced a grant program designed to boost fertilizer production
Line chart shows US food and energy independence. The US has been a net exporter of food by a small amount, from 1975 to 2022. The US was a net importer of energy until 2020, when they achieved energy independence and became a net exported
Line chart shows European Union food and energy independence. The EU has been a net exporter of food from 1975 to 2022. The EU is a net importer of energy, and this has grown more drastic in 2022
Line chart shows the consumer price index for food in the US and the EU. Both series have spiked up in 2022 to levels not seen in several decades
Line chart shows US corn prices from 1992 to 2022. Corn prices are around $8 per bushel, which are the highest levels seen in the last decade
Line chart shows the North America fertilizer price index from 2002 to 2022. Levels have come down from all-time highs of almost 1,300, and are now around 800
Bar chart shows Russia and Ukraine’s share of global exports in 2021. Russia and Ukraine typically account for 15-20% of global fertilizer exports
1 Export bans on refined products could lead, counterintuitively, to higher gasoline prices. A refined products export ban could divert gasoline supplies to domestic markets rather than foreign ones. But given low diesel demand in the Northeast, refiners could also be stuck with excess diesel that they would have to store (i.e., an expense rather than revenues). If so, refiners might actually cut runs until overall refining profitability per barrel is restored. A temporary Jones Act suspension might be needed as well in order to avoid domestic shipping costs offsetting the benefits of increased gasoline supply. A better solution: an export ban on gasoline only, allowing diesel to still be exported. See JP Morgan Commodity Research, June 22, item #7.
2 In a future world of much greater renewable energy, US energy independence would decline: China is by far the largest producer of PV modules, wind turbines, lithium ion batteries, electric vehicle mineral processing and related cathode and anodes.
3 “JPMorgan tells employees the bank will pay for travel to states that allow abortion”, CNBC, June 24, 2022. Maybe one day the firm will allow me to write a piece on the history of the 14th amendment, substantive due process, the 70 years of Supreme Court cases which led to Roe and Casey in the first place and the economic consequences of repeal. Seismic shifts from the Supreme Court may not be over: watch for a ruling on “major questions” and nondelegation doctrines. The Court might end up curtailing the ability of the Executive Branch (EPA, OSHA, USDA, DOL, etc) to promulgate rules, requiring Congress to pass legislation instead.
4 JP Morgan Global Markets Strategy Flows & Liquidity Report, June 23, 2022, see exhibits 2 and 4
5 One reason for the recent improvement: WeWork lost less money by reining in its footprint rather than by growing revenue or growing cash flow from operations. I thought it was notable that according to Bloomberg, the only two firms with research analysts covering WeWork are Mizuho Securities and Piper Sandler.
