ExxonMobil, repo markets break down

Plus new inflation numbers, China goes up to 3, Brexit drains London

Hello and welcome to a holiday-delayed edition of Contention! Please enjoy 8 minutes of highly liquid dissident business news. In this edition we cover:

  1. Repo markets put Fed in a bind

  2. ExxonMobil loses, climate doesn’t win

  3. Rapid Round: Inflation, meat and cars; China combats aging; Britain loses billions to Brexit

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Repo markets put Fed in a bind

Markets reversed their recent slides last week as reopening optimism overtook policy fears -- the Dow was up 0.9%, the S&P 500 1.2% and the Nasdaq 2.1% with 10-year Treasury yields dipping below 1.6%. 

But markets seem to be discounting the week’s most important story: the Fed’s “reverse repo operation” hit record demand on Thursday, with 50 counterparties “lending” the central bank $485.3 billion overnight. Repo markets are short-term, secured debt markets used by banks, hedge funds, and money market funds to minimize the cash on their books by lending to one another in return for Treasury bonds as collateral. 

As recently as April, the Fed’s facility had nearly zero demand. The story of how it got from there to half a trillion dollars a day will end in a tough decision for the Federal Reserve very soon.  

The simplest explanation: a glut of liquidity is overwhelming financial markets worldwide. The Fed created much of this as part of an effectively never-ending “Quantitative Easing” (QE) policy since 2008, steadily purchasing Treasury bonds and mortgage-backed securities. Extraordinary stimulus spending from the federal government has only added to the flood. 

What happens when extra money supply flows into an economy? Conventional economic wisdom answers this question with the “quantity equation”: MV = PQ. The money supply (M) and the velocity of money (V, the amount of times the same dollar gets used in successive transactions) determine prices (P) at a given quantity of output (Q). 

If M goes up, P should too -- money supply determines prices, according to the theory. Assets were crashing in 2008, and a deflationary crisis loomed, so the Fed propped up prices with QE. 

But this very simple model misses something big: savings. Once you include money hoards into the world of the equation, it flips on its head: PQ = MV. The scope and scale of production determines the money supply. 

Not enough money in circulation to buy up all the commodities you need? Money will come out of savings, banks will create it through lending, or worst case, businesses will switch to some alternative currency. More money than you need for your given level of output and velocity? The excess will go into savings. 

But remember: the Fed issued the money by buying up Treasury bonds, artificially bidding up their prices, suppressing interest rates. So instead of getting parked in bonds, deposits, or other interest-bearing vehicles, the excess cash instead flows into “risk assets” -- stocks, real estate, corporate debt including “junk bonds,” cryptocurrency, etc. -- just to get any return at all.  

Wall Street loves this. Central banks have turned the zero-sum “buy low, sell high” game into a win-win “buy high, sell higher” market by steadily pumping out liquidity at negative real rates. 

Enter last week’s eye-popping reverse repo number. All of that liquidity ends up in bank accounts sooner or later, and deposits are liabilities for banks -- they have to pay interest and deposit insurance premiums on them. Banks normally park excess deposits at the Federal Reserve -- the banks’ bank -- which in turn pays them interest, turning the money-losing deposit liability into a money-making reserve asset. 

But the more assets a bank has, the more “highly liquid” capital -- not customer deposits, but the bank’s own money -- it is required by law to keep on hand. This discourages excess risk taking and covers losses if the bets don’t pay off. 

This is why they are instead flooding the repo markets, hoping to earn small yields lending the cash to investment funds that need it to close trades and withdrawals. But these funds are glutted with cash too, and they are demanding payment to take on even more -- repo rates have turned negative, i.e. banks are paying to lend money out. 

This puts banks in a lose (deposits costing them money), lose (Fed accounts increasing capital requirements), lose (negative repo rates) situation, a material risk for the entire financial system. This is why the Fed stepped in to put a floor under the repo market, offering to “borrow” cash at zero percent interest, better than negative rates. 

This puts the Fed in a precarious position. First, it’s hard to argue that it should continue QE -- buying Treasury bonds -- when there is a glut of cash and a shortage of bonds for collateral. But “tapering” QE will likely mean big headwinds for stocks

Beyond all of this, last week’s record means that the Fed has essentially nationalized the repo market, exactly the kind of ever-increasing state intervention into markets dissidents have long predicted. 

The Fed has to decide which risk to tolerate: “losing control” of its short-term rates, eroding its credibility, or threatening Wall Street’s 13-year pump-and-pump feeding frenzy. Most likely they’ll try and split the difference, patching up emerging contradictions with a cascade of new interventions. Washington’s predictable priority: minimizing ultimate costs to major investors, leaving everyone else holding the bag. 

ExxonMobil loses, climate doesn’t win

Activist shareholders scored an historic victory over ExxonMobil’s management Wednesday, as at least two dissident directors won seats on the energy giant’s board of directors. Led by socially-conscious hedge fund Engine No. 1, the campaign is meant to turn ExxonMobil towards a more climate-conscious future.

The only problem: the winners have no idea what they want and even less of an idea how to get there. Their strategy to solve the climate crisis in corporate boardrooms has no chance of succeeding. 

Engine No. 1 sought to place four directors on ExxonMobil’s 12-seat board, and secured at least two -- veteran energy industry executives Gregory Goff and Kaisa Hietala -- with other votes too close to call. Executives led by CEO Darren Woods resisted Engine No. 1’s efforts in one of the most expensive proxy fights ever. 

High-profile recent commitments to “ESG” -- environmental, social, and governance -- investment strategies by major funds won out in the end. Large pension funds, BlackRock, and T. Rowe Price all voted for at least some of the upstart candidates.  

This is a big upset, but the actual climate consequences are likely to be limited. Goff and Hietala both hail from the oil-refining industry. This makes sense for ESG investors: ExxonMobil, main U.S. rival Chevron, and other hydrocarbon companies are major components of most ESG funds. There is no real definition for “ESG,” and most of the major ESG investment funds are identical to S&P 500 index funds -- a 99.7% correlation. 

So why vote against management if the petroleum behemoth is already so environmentally-friendly? The move is tied up in another business-friendly, ill-defined concept: net zero climate emissions.

Activists want ExxonMobil to commit to a net zero target -- a point at which its greenhouse gas emissions will be offset by greenhouse gas removal from the atmosphere. More than a fifth of the world’s largest companies have set net zero targets. CEO Woods has resisted the demand because the company has no idea how to get there, for the simple reason that nobody knows how to actually get to net zero.

Cutting emissions is easy enough, and earlier this month the International Energy Agency in its most comprehensive net zero report to date said that the world’s energy companies need to end all exploration and development of oil and gas this year if there’s any chance of anybody getting there. This is not going to happen: even the rosiest predictions of oil demand reduction has consumption at 85% of present levels a decade from now. 

As for the offsets, the least problematic solutions do not exist at scale yet. More concerning is the one solution at the heart of all scenarios: “bioenergy with carbon capture and storage” or BECCS. 

BECCS is a sort of climate Ponzi scheme: grow fuel crops to pull carbon out of the atmosphere, burn the crops to generate energy, but capture the carbon and store it underground somewhere. Like all Ponzi schemes it fails due to insufficient inflow -- there is not enough land in the world to reach the level of offsets implied by net zero frameworks. Anywhere from 25-80% of all agricultural land would have to be converted to fuel production.

This means huge increases in food prices and irrigation needs that could raise water prices 460% in some parts of the world. Net zero means that rich countries get to emit while poor countries do the offsetting

And this is the best case scenario. If BECCS and still-hypothetical technologies can’t sufficiently offset the emissions ESG advocates plan to continue, we’ll get runaway ecological catastrophe instead of mass thirst and starvation. 

In this context, it’s hard to fault ExxonMobil’s management -- at least they admit that the best strategy in the face of uncertainty is to make as much money as possible, and fossil fuels are much more profitable than renewable alternatives. Good news for them: their new bosses aren’t likely to change very much. 

Rapid Round

Inflation pressure rises, automakers shut factories

The core personal consumption expenditure (PCE) index -- the Fed’s preferred inflation gauge -- rose to 3.1% in April. This was the biggest increase since 1992, and higher than the 2.9% expected. If annualized over the past two months, the current rate would indicate the worst inflation since 1985.

Driving the surge: a COVID-induced “persistent reallocation shock” to production and demand rippling through the economy. Nowhere is this more evident than in cars, as production lines struggle under a global shortage of semiconductors. Last week Nissan, Suzuki, and Mitisubishi all halted production in the face of inadequate chip supply.  

Food inflation is also on the rise, led by meat prices. A May survey of 2,200 consumers found a third of them reporting higher grocery prices, led by red meat and chicken. The price surge has meant record profits for big meatpackers such as Tyson and Cargill. But driving their gains: worker deaths in the packing industry due to COVID-19, helping to fuel the price rise.

China scraps two-child policy

The Communist Party of China’s Central Committee eliminated the country’s two-child policy for married couples on Monday in favor of a three-child policy. This comes after China’s latest census reported a total fertility rate of 1.3%, well below the 2.1% replacement rate, contributing to an aging of the population.

In 2020, China’s population rose by 12 million -- more births than deaths, but at the lowest pace since the 1950s. The population will likely peak this decade, contracting the labor force and inducing a slowdown in economic growth. By 2050, the percentage of the population above the retirement age could rise to 39%, much greater than other countries.

Reversing this trend is likely impossible through encouraging more childbirths. Another solution: replacing manual labor on a massive scale with automation and robotization -- powered by a state-supported 5G network which is part of the party’s 14th Five-Year Plan. 

To support the elderly, the party pledged on Monday to redouble efforts on “national overall planning of basic old-age insurance for employees” and “improve the multi-level old-age security system.” To ease pressure on families, the party promised to crack down on employer hiring practices that unfairly privilege male employees over young professional women.

Ireland’s boost from Brexit 

The United Kingdom’s services exports declined by more than $156 billion since the 2016 Brexit referendum, according to new data. Worst hit: financial services, all-important to Britain’s key role as the world’s broker and center for foreign currency exchange trading. Business services, travel, transport and information technology also saw declines.

Brexit’s toll contributed to a rise in Ireland’s services exports by $179 billion in the same period. That is partly due to big tech companies’ existing footprint in the Irish republic, now combined with the accelerating shift of service companies moving away from Britain. 

The other big winner from Brexit: Amsterdam, which has gained much of the trading platforms and stock-and-swap trading leaving London. On Monday, the Netherlands extended a deadline for British citizens to apply for permanent residency to Oct. 1. However, time is running out for British citizens in France, Malta, Luxembourg and Latvia who have until June 30. Fourteen other countries including Germany automatically enrolled their Britons into a legal, post-Brexit resident status.


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