There are a lot of quarters where there isn’t much happening in the world to talk about. This is not one of them. We have a war in Europe, oil over $100, wheat and corn prices at decade highs, the NASDAQ dropping 20% to name a few things that have happened this year. Let’s talk about it.
There is a joke in our office that when Mark leaves town crazy things happen. Mark was in Nicaragua when Brexit occurred. The markets were down almost 10% on that news. To celebrate his 30-year wedding anniversary in 2011 he went to London where riots broke out and the markets were down again by over 10%. In 1990 he was in Disneyland when Saddam invaded Kuwait. This time he was in Florida on a four-day vacation when Putin invaded the Ukraine. The obvious solution to this problem is to cancel all of Mark’s vacations and keep him at work. We will let you know how that goes.
When the war broke out on February 24 th , it was assumed by most pundits that Russia would roll over Ukraine in 72 hours. It was a forgone conclusion that it would happen. As we type this letter on the last week of March, that assumption has proven to be a bad one by the media and Putin. This war has changed the economic outlook of just about every country in the world. It’s not for the better.
Russia and Ukraine export around 25% (source NY times) of the world’s wheat production. They are also key suppliers of barley, corn and sunflower seed oil. To make matters worse, Russia and Belarus are the second and third largest potash (used to fertilize crops) exporters. They also are accountable for 17% of the world’s nitrogen used for farming. The sanctions placed on the banks and the exporters of Russia make it very difficult to gauge how much food or fertilizer is going to be shipped. If you want to get a letter of credit to buy anything from Russia, it will be very difficult. Even if the bank sanctions exclude food or fertilizers in the future, it’s doubtful you are going to get what you want from them if the banks are afraid to finance them. As we type this, we are under the assumption that the price of food will go much higher than the consensus thinks today. Why?
We have written about how cheap commodities are for about five years. We have also written when you print as much money as the world has it eventually ends up in “stuff” like commodities. This war lit the match on that money. Russia’s GDP is estimated at $1.4 trillion which is about 2% of the worlds GDP. If you think about it, that seems out of whack with reality. That GDP is way too low for what they produce. We own Apple’s stock and its market cap (GDP in this example) is $3 trillion. In our way of thinking about things, Apple is valued more than Russia. We own Apple and are big fans of it. However, if we must choose between food versus an I phone we will choose food. Russia is valued at 2% of the worlds GDP but it accounts for about 25% of its food production. This is a crazy mismatch in valuations. Same goes with Latin America. They produce lots of “stuff” and their stock markets have been horrible for eight years. Why? Investors wanted tech over “stuff” and took for granted the food and energy we consume. Today Latin America stocks are the number one markets in the world in 2022. Stuff is back.
We are not advocating investing in Russia. What we are advocating is invest in areas of the world where Russia’s problems are somebody else’s gains. We did not see this war coming five years ago when we started writing about inflation. We are positioned to benefit from it, due to our view that energy and food are too cheap versus the other things we consume. This war will expose the weakness of the food supply chain. Let’s talk about oil.
We own oil stocks. They have been good to us so far. The world consumes about 100 million barrels of oil a day. It produces about the same. Russia produces around 10 million barrels of oil a day of which they export 7 million of it to the rest of the world. If the world stops buying Russian oil because of sanctions, you have removed 7% of the world’s oil exports in just one month. You can’t replace that quickly if ever (we vote never). When the markets saw the potential for Russian oil to not “circulate” they bid up the price of oil to over a $100 a barrel. At some point prices will go high enough that you will get demand destruction and the world won’t consume 100 million barrels a day but less. How high does oil have to go for that to occur?
As you can see from the chart, oil consumption as a percentage of American consumer’s paychecks are not near historical highs. It’s not close. What this tells us is that oil is going higher than it is now to get our consumers to change their behavior and consume less oil. The average percent that a consumer has spent on oil in the last 60 years is 4.82% of their income. Today we are spending about 3.8%. If you try and guess what the price oil would be to get to the average of 4.82%, we think it is over $130 a barrel. If oil went to some of the spike highs, we have had in the past oil could get to around $200. At a time when we are having a major supply shock from Russia, we are also having impediments to drilling imposed in the USA from our government. We also have clean-energy advocates pushing the large oil companies to not drill for oil anywhere in the world. This is going to make it very difficult to increase oil production in the states. It’s our best guess that oil production here heads south and doesn’t come back to the previous highs of 13.2m barrels a day (we are at 11.6 today). We have had a 20-year low in drilling in the US for the last 2 years. We don’t see that changing anytime soon. When you add all of this up, we think oil over $130 is a good bet. As of this writing we have not sold any of our oil holdings.
To give you another way to size up commodities versus stocks, we keep track of the ratio of commodities and oil to the stock market. In the last 35 years the ratio of the S&P 500 index price divided by the price of a barrel of oil is around 25. Today that ratio is at 43 (S&P 500 4600/$107 Oil). Based on this ratio, stock prices are still 70% above their statistical average versus a barrel of oil. If the S&P was to stay at 4600 the ratio would be at its normal range of 25 if oil went to $184. Again, the most likely scenario is oil goes up. Of course, stocks could tank to 2675 and put the ratio at 25 when oil is $107. Our best guess today is oil goes up rather than the S&P goes down. You can also use this ratio for a basket of commodities. A basket of commodities usually represents about 15% of the S&P 500. Today that number is 7%. Again, the message is the same. Commodities are still undervalued versus equities.
The yield curve is worrying investors. What’s a yield curve? The yield curve is the difference between two maturities of treasury bonds. Most investors use the spread between the 30-year treasury bond and the 3-month T-bill. Other use the 2-years to 5-year spread. Some use the 2 to 10. As the difference between these two maturities narrow economists believe it helps predict a recession. If the spread is widening it predicts an increase in economic activity.
The spread above is the difference between 2-year treasuries and 10-year treasuries. As you can see the spread is now basically zero. The market is anticipating a dramatic slowing down of the economy. We think that the economy will slow down but not enter a recession. The yield curve can be narrow or inverted for quite a while before the economy finally gives up and heads south. We wanted to show you this chart just to let you know that the markets are worried about. We hope they are way early.
As always if you have any questions give us a call at 417-882-5746.
Sincerely,
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR