The market’s wrong bet

Friday, 10 November 2023 — Melbourne, Australia

[2 min read]

Dear Reader,

Let me kick off by thanking all the Fat Tailers who made it to our gathering last night at the Windsor Hotel in Melbourne. It was a great night, and we hope you enjoyed it as much we all did. It’s been too long since we last had the opportunity to meet face-to-face.

People travelled as far as New Zealand, Perth, and Far North Queensland. Thanks to all who made it such a great night.

I’m campaigning to have the next event in Wollongong. Drinks and canapes by the beach sounds pretty good. And it’s just a short trip down the road for the Sydneysiders.

It’s an event for paying subscribers only. So make sure you sign up to a service to get the next invite!

Meanwhile, in other news. Well, it’s not news to 99% of us.

The financial review reports…

‘Economists have urged Treasurer Jim Chalmers to overhaul Australia’s tax system after new data showed households suffered the largest fall in living standards of any advanced economy over the past year.

‘Inflation-adjusted disposable incomes have hit their lowest level since June 2019 as high inflation, a rapid increase in mortgage repayments and rising income taxes ravage household budgets, newly released data from the OECD show.’

Jim Chalmers and his mates in Canberra, who make up the 1%, are too busy overhauling our energy system to worry about the plight of the plebs.

As we continue on the path to Not Zero, the fall in living standards is only going to get worse. Cheap and reliable energy is the backbone of a healthy economy. Yet our politicians are hell-bent on making it expensive and unreliable.

This is partly why this week’s interest rate rise is in some ways pointless. As I discuss with Kiryll in this week’s episode of What’s Not Priced In (see below), is the rate rise going to lower petrol or electricity prices? Is it going to create more housing?

You know the answer to that.

For more, see Kiryll’s thoughts below.

Before that though, there’s one small favour I’d like to ask of you.

We’ve been sending Fat Tail Daily to your inbox for a little over a week now, and we’d love to know how you’re finding this new-look, new-form email.

If you could spare a couple of minutes to complete this brief survey for us, we would greatly appreciate it. Any and all feedback is welcome.

Now, onto Kiryll…

[5 min read]

Dear Reader,

Journalists have the Five Ws. Who? What? Where? When? Why? Five questions to find the truth.

Investors only need one.

What’s not priced in?

Searching for the answer will direct you to all the right areas.

The reason is simple.

Investing is about differentiated insight. Be right and set yourself apart from the crowd.

You don’t want to join the crowd. You want the crowd to join you.

The market is a giant decentralised bookie.

It assigns odds to countless outcomes — recessions, rallies, individual stock performance…

And like legendary punter Steve Crist said, the path to consistent profit lies in exploiting the ‘discrepancy between the true likelihood of an outcome and the odds being offered’.

In this episode of What’s Not Priced In, Greg Canavan takes us through why the market is still underpricing the risk of recession.

The likelihood of recession is not certain.

But it's higher than the bookie thinks.

US valuations stretched

US stocks rallied this fortnight. Some attributed that to the Fed’s pause. Greg pointed to previously oversold positions instead.

At the end of October, the US stock market was heavily oversold.

The bounce was inevitable.

The question is, can the rally continue?

Greg is doubtful.

The problem is valuations.

The S&P500 is trading on a forward earnings yield of about 5.6%. This assumes earnings per share rise over 10% in FY24.

Is that likely?

For Greg, this is a low probability outcome.

Not to mention that the current US 10-Year bond yield is hovering at about 4.60%. Meaning the equity risk premium is slim.

When the stock market yields only ~1% more than the risk-free rate, there’s little reward to compensate for the risk.

So US stocks remain stretched.

RBA is not Superman

German philosopher Immanuel Kant asserted years ago that ought implies can. Responsibilities, to Kant, entail a capacity to fulfil them.

Responsibilities are like mandates.

And the Reserve Bank’s mandate is to keep the price level steady and unemployment low.

The RBA ought to. But can it?

As we discuss in the episode, sometimes not.

The RBA can’t do much about the price of electricity, housing, or petrol.

Entrusted with keeping inflation under control, the RBA’s mandate sometimes outruns its capacity.

The RBA is not a superhero. Let’s lower our expectations of its powers.

Not to mention that just because the RBA’s job is keeping prices stable doesn’t mean state and federal governments can’t help.

State and federal governments can ease inflation, too.

Often, they choose not to.

More on that below.

Hansard surfing

Ian McEwan’s The Children Act was inspired by reading family court judgements.

‘It was the prose that struck me first. Clean, precise, delicious. Serious, of course, compassionate at points, but lurking within its intelligence was something like humour, or wit, derived perhaps from its godly distance, which in turn reminded me of a novelist's omniscience.’

Hansard transcripts of parliamentary testimony by RBA officials don’t hold the same literary promise. But they do have uses.

Fronting a hostile audience, Reserve Bank officials are often more forthright than their written communiqués.

Take this testimony earlier this year from former governor Philip Lowe.

Asked if governments can ‘help or hinder’ fight inflation, Lowe said ‘in principle they can’:

‘Decisions that are made by the parliament can affect inflation in at least three broad ways. A more restrictive policy stance — let me be clear about that; that involves higher taxes or less government spending — would mean less aggregate demand in the economy and less inflation. The second thing governments can do is structural reform that increases the supply side of the economy so it grows more quickly, so a given level of aggregate demand doesn't put upward pressure on prices —so it can do things on the structural front. The third thing governments can do is intervene in specific markets to reduce price pressures; we saw an example of this recently in the electricity market…’

We can see that in Australia with house prices.

Despite a dizzying rate hike cycle, Australian home values are rising again.

As Greg stressed, this has little to do with monetary policy.

What’s funny is that RBA officials know this.

In her recent appearance before a parliamentary committee, Muchele Bullock was grilled about rising rents.

A senator wanted to blame the central bank. Bullock pushed back. The problem, she said, was lack of supply:

‘The problem with the rental is not interest rates. The problem is that demand for rental properties is too high relative to the stock of rental properties. Immigration is adding to demand for properties. Which adds to demand for rental properties, which adds to pressure on rents.’

Lowe was even blunter in his final parliamentary showing:

‘The supply side of the [housing construction] market is not flexible — let's put it politely — and it's not flexible largely because of regulation, planning, zoning, developments and charges. So there is a lot of regulation there which is affecting the flexibility of the supply side of the housing market, and the result of that, with strong population growth, is rising housing prices and rising rents.’

And that leads to a puzzle.

Population, housing stock and catch-22

How do you ease inflationary pressures caused by population growth without doing anything about immigration intake?

We just mentioned housing.

If immigration policy remains unchanged, rents and home prices from population growth can only slow with more supply.

More housing, more properties, more rentals…

But you can’t have more housing without more spending.

Michele Bullock last month said as much before the Economics Legislation Committee:

‘In many of the states, particularly in New South Wales and in Victoria, there is infrastructure spending, and the fact is that we need spending on infrastructure. We've got a growing population, and we need that spending on infrastructure. You can't just halt these things.’

Spending on infrastructure boosts demand. For workers, materials, equipment…

In a tight labour market, rising demand boosts wages.

Wages is a key component of services inflation.

And what is the Reserve Bank worried about most? Slow progress with taming services inflation.

Looks like we’re in a pickle.

What else caught my eye this week

‘Many firms issued long-term debt when rates were low, and so continue to enjoy low financing costs today. Net interest payments by America’s companies have actually fallen this year because the interest they earn on the cash they keep to hand has risen faster than the cost of servicing their debts.’

Looks like duration risk has its benefits!

‘Although the U.S. population has grown in recent years, the nation’s gasoline consumption has increased more slowly in comparison, meaning U.S. gasoline consumption has been decreasing on a per capita basis. We forecast the average person in the United States will consume 402 gallons of gasoline in 2024, down from a peak of 475 gallons per person in 2004. Because of lower per capita gasoline consumption, we forecast overall U.S. gasoline consumption to decline in 2024 to 8.83 million barrels per day (b/d), from 8.88 million b/d in 2023 and down from the 2019 pre-pandemic average of 9.31 million b/d.’

On a final note, thank you to everyone who came down to Fat Tail’s get-together in Melbourne. It was a pleasure meeting readers (and podcast viewers!).

Despite bashfulness, I enjoyed chatting to you all! Hope it was reciprocated!

Regards,

Kiryll Prakapenka,
Editor, Fat Tail Daily

[4 min read]

Dear Reader,

Do you remember Dieselgate? It’s just one episode in a long history of governments wreaking havoc on the environment by trying to save it. As this particular story goes, governments encouraged people to drive diesel cars because they emit less CO2 and would thereby save the planet.

My Japanese father in-law reckons he was paid about AU$7,000 to import a diesel car from Germany into Japan because of its environmental credentials.

As the Guardian put it:

‘Diesel was touted at inception as a wonder fuel. It was a way of driving cost-efficiently while doing your bit to save the planet. Government, industry and science united to sell us the dream: cars running on diesel would help us cut our CO2 emissions as we eased smoothly into a new eco-friendly age.’

Unfortunately, that turned out to be a bit misleading, with diesel cars emitting far worse than CO2 instead…and far more CO2 than dodgy tests had measured to boot.

Governments eventually reversed their pro-diesel policies, but not before diesel cars had flooded many cities with their noxious fumes.

Now, we don’t know how many people were killed by governments encouraging people to buy diesel cars to reduce CO2. The EU’s Environment Agency estimates about 71,000 premature deaths in Europe alone were caused by diesel fuels, which probably did reduce a lot of CO2 emissions, ironically enough…

I wouldn’t mind seeing Niall Ferguson of COVID modelling fame do the maths for diesel subsidy fatalities on a global scale though…

But why bring up all this awkward information? Wouldn’t those who survived governments’ previous flagship climate change policy rather forget about the whole thing? Well, it might be about to repeat itself one a much larger scale. I’m calling it ‘Gasgate’.

Petroleum gas is Australia’s third largest export and Australia is the fourth largest exporter worldwide. At $39 billion, it’s 11.4% of our total exports.

Gas is a key business for many of our largest and most widely held stocks, including AGL, Woodside Petroleum, BHP, Origin Energy and many more.

Natural gas provides about a quarter of our energy needs and a fifth of electricity production.

Gas is the key partner to the rollout of renewable energy because it is reliable and can be controlled easily to balance the intermittency of having renewables on the energy grid.

Gas is, in other words, a crucial part of our future in terms of the energy we use, the economy we live by, and the stockmarket we feed with our compulsory super contributions…

And it is projected to remain so for many years to come.

But all this is based on the assumption that gas is cleaner than coal…or should I say presumption?

You see, an analysis by Cornell University’s methane expert, Robert Warren Howarth, which hasn’t yet been peer reviewed, says otherwise.

It claims that, because of the methane emissions released during the production, processing, transport and use of LNG, its carbon emissions equivalent is actually higher than coal.

If true, this is a bit of a problem, to say the least.

It implies that the vast transition to a mix of renewables and gas to back them up is about to come crashing down in a putrid cloud of methane and lost shareholder value.

The first implication is fairly obvious. If LNG is to the power grid what diesel was to cars, then it will suddenly become a lot less popular with governments and companies hoping to cut their CO2 emissions. This leaves a big smelly hole to fill in terms of energy supply.

For Australia, the claims in the upcoming paper are especially worrying because we have made gas a key part of our exports. Unfortunately, that’s where it all goes wrong in terms of methane emissions too, with shipping causing a good chunk of the methane leakage.

This further implies that LNG as an internationally traded energy source will be especially environmentally damaging and therefore especially shunned by anyone who still has faith in environmental science at this point. All those gas import and export terminals being built around the world could be sunk by their own carbon miscalculations.

More intriguingly, what’ll happen to renewable energy if it is robbed of its favourite scalable balancing mechanism because it emits too much? What level of renewables will be viable on a grid if we can’t use a lot of gas to fill the gaps in intermittent energy production?

The whole renewables thing could come crashing down even faster than it has been over the past few weeks anyway…

All of this is mighty ironic, of course. The same environmentalists who robbed us of emissions free nuclear power, and who are hoping to stop us from eating beef because of methane emissions, are about to discover that the only fossil fuel they can tolerate because of its partnership with renewables emits more CO2 equivalents than their bogey man coal by way of methane emissions. You couldn’t make it up...unless you were a diesel driver.

Of course, it’s important to remember that energy policy has a turning circle that makes the Titanic look unsinkable during an ice age. Heck, diesel remained hugely popular for years after the Dieselgate revelations, largely because governments didn’t want to pull the rug out from under the drivers who were naïve enough to buy into the science and subsidies, literally. For once politicians kept their promise, at the expense of those of us who need to breathe to survive.

And so gas may yet have a bright, if odorous future for some years to come. But only if governments turn a blind eye to the science…

Until next time,

Nick Hubble,
Editor, Fat Tail Daily