E-piphany

For a few hours, Americans actually paid attention to news from the United States this morning. It wasn’t the continued weakness in Initial Claims (386k this week, with last week revised up to 392k) that involved investors in domestic affairs for a change, but rather the drama of the Supreme Court’s decision on Obamacare. Just after 10am, the Supreme Court handed down the eagerly-awaited/dreaded decision, and it contained a surprise for just about every observer. The Court upheld the vast majority of the law, including the individual mandate that had so agitated conservatives. But the majority actually held that the law would have been unconstitutional under the commerce clause of the Constitution, which was the argument of those who wanted the law struck down. The interesting twist is that they also ruled the mechanism still worked because it can be construed to be a tax, rather than a ‘penalty.’

In other words, if the law said that you must take an insurance policy or else you’re guilty of a crime, it would have been unconstitutional per se. But the law offers a choice, however bad, that allows you to evade the requirement of the law: you can just pay a rather stiff fine. According to the Supreme Court, that makes it a tax and since it doesn’t force anyone to enter the stream of commerce – it merely persuades them financially that they ought to – it doesn’t run afoul of the Constitution. Bad law, perhaps, but not unconstitutional.

It’s an interesting and depressing ruling. Since there is no limit on the amount of money the government is permitted to levy in taxes, there would be no difference in principle if the Congress had made the “opt-out tax”, say, $100 million, completely bankrupting anyone who refused to comply. It strikes me as a plausible ruling (not that I am a Constitutional lawyer), though I’m not pleased with the result, and anyway it’s the law of the land. But the implication is that your ‘inalienable rights’ are not life, liberty, and property (aka ‘pursuit of happiness’), but life and one of liberty or property. You can give up your property to keep your liberty, or give up your liberty and keep your property. Thanks, Congress.

The stock market reacted instantly, driving lower. Actually the damage was not as severe as I expected it would be, but that’s probably because Europe was still lurking with headlines to come. But in a weird way, the implications for the stock market are in my mind somewhat positive. Hear me out: I think this is the worst possible outcome for Obama, because this decision will energize the right and those who are not on the right but oppose the health care bill (54% of Americans still favor repeal, the same percentage as right after it initially passed two years ago), and American elections are about turnout. As they did four years ago, the Republicans have nominated a dull, milquetoast candidate; but four years ago the citizens who self-identify as Republicans were tired of spending eight years of having defended Bush and by contrast, those same voters are now energized to get out and vote. A Gallup study earlier this year found that since 2008 the number of states that were either “Solid Democratic” or “Lean Democratic” fell from 36 to 19, while the number of states that were either “Solid Republican” or “Lean Republican” rose from 5 to 17, based on professed party affiliation. There were 15 “Competitive” states, and that’s where the suddenly-energized anti-Obamacare voters can tip the balance. Included in that list are states like Pennsylvania, Ohio, and Florida, where the Presidential election has been won or lost in recent years. Oh, and by the way: older Americans (think: Florida) like Obamacare even less than younger Americans who don’t use as much health care.

So, had the Supreme Court struck down parts of the law, both parties could have engaged with voters on what they would do to fix the law. But now the Democrats are forced into defending a piece of legislation that a majority of Americans say they want repealed, and Republicans are saying they will repeal it. That’s a much tougher landscape for the Democrats, and that’s good for equities.

However, the election is still a long four months away, and in the meantime we have a lot of Europe to get through.

As I noted above, the stock and bond markets had flattened out and quieted down – with the S&P down about 10-15 points and bond yields down a handful of basis points – within an hour or so of the ruling. Ironically, Europe provided bullish news when Herman Van Rompuy (the first, and perhaps the last, EU President) declared that the EU had agreed on a new growth pact. Stocks shot higher in moments, almost finishing the day with gains but in any event with slim losses. Unfortunately, it proved a mirage – apparently they “agreed” on a relatively small €120bln deal, but hadn’t completed the details. To me, that means they haven’t agreed on the pact, but perhaps agreement means something else in Brussels. Apparently, though, Spain and Italy were upset at hearing there was a deal even though their concerns – namely, a desperate plea for short-term measures to support their bond markets – hadn’t been addressed, and as of this writing those two countries are blocking the deal (although Van Rompuy said he “wouldn’t say there is a blockage, discussions are ongoing”). So we will see what dinner brings, but if the best that comes out is a mere 120bln-euro deal then it is fair to say that nothing really happened and the Treasury selloff can be delayed somewhat longer!

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I promised yesterday some words on oil and TIPS. Several people recently have forwarded this article to me, by a Harvard professor, asking for my opinion; it is purported to debunk the “peak oil” hypothesis.

I suppose that the insights in the article are somewhat useful, but it doesn’t really have anything to do with the real theory of “peak oil.” The peak oil hypothesis holds that since production in any given oil field tends to rise, peak, and then sharply decline, and since most of the mega-fields are fully mature and the pace of discoveries of new fields has declined, the global production of oil will eventually decline.

But the hypothesis of course isn’t about the absolute impossibility of producing more oil – we could always assemble molecules by hand in a lab – but involves two different and hard-to-dispute facets: (1) If traditional oil fields grow, mature, and die, and we don’t discover more oil fields, then the amount of oil produced from traditional oil fields must eventually decline. (2) The theory doesn’t say that no alternative fuel will be developed; it isn’t called the “peak energy” hypothesis but the “peak oil” hypothesis! Arguably, oil that is produced from shale or with other advanced technology is an alternative fuel in the sense contemplated by the original Peak Oil hypothesis. But the availability of these alternative fuel sources, or alternative methods of extracting oil, is clearly related to the price of the fuel that is being displaced/replaced. “Peak oil” is a phenomenon that holds ceteris paribus, in particular at unchanged prices.

The price that was extant when “Peak Oil” theories first developed was far lower than it is now. And, for a long time, supply acted more or less as Peak Oil predicted it should, because production is constrained in the short run. But higher prices elicit a higher quantity of supplies, in the long run, of virtually any good. This paper provides proof that (a) this works in the long run but (b) there’s a long lead-time – the author declares the surge in spending on R&D began around 2003, and as long as there isn’t a major decline in prices before 2015, his predictions should come to pass.

The ‘prediction’ of a collapse in crude prices has drawn a lot of attention, but the author makes such a collapse contingent mostly on demand-side events:

“In particular, a new worldwide recession, a drastic retraction of the Chinese economy, or a sudden resolution of the major political tensions affecting a big oil producer could trigger a major downturn or even a collapse of the price of oil, i.e. a fall of oil prices below $70 per barrel (Brent crude)…

“Coupled with global market instability, these features of the current oil market will make it highly volatile until 2015, with significant probabilities of an oil price fall due to the fundamentals of supply and demand, and possible new spikes due to geopolitical tensions. This will make difficult for financial investors to devise a sound investment strategy and allocate capital on oil and gas companies.

So the main shock conclusion is that higher prices for oil beginning in the 2000s led to more R&D and ultimately more production, which could eventually lead to lower prices if demand doesn’t keep up. Wow, give that guy a Nobel prize! I’m actually more interested in the author’s conclusions about the distribution of energy production; he basically suggests that these new technological developments will greatly democratize the production of oil and remove much of the specialness of the Middle Eastern oil patch. That would be welcome, surely.

A surge in energy production is great news, of course, and I would love to believe that the real price of oil will decline (the nominal price will not, if the price level advances sufficiently – so keep in mind we’re talking about the real price) since the developed world really needs a break.

But TIPS are taking the idea of a collapse in oil prices too far. The first two TIPS issues (after the July-2012s which mature in two weeks) are the April-2013s and the July-2013s. At today’s close, they yielded 0.46% and -0.44%, respectively. Let’s first think about the April 2013s. April 2013 nominal Treasuries sport a yield of 0.20%, which means that the April TIPS are implying an outright decline in prices (aka deflation) between now and January and February of next year, when the final payment will be set for that issue. While gasoline futures are significantly backwardated, implying that traders expect energy prices to continue to decline, there’s nowhere near enough drag to imply a decline in the aggregate CPI over the next eight months. We think the gasoline market is implying CPI ought to rise about 0.8% over the next eight months, which means those TIPS are substantially cheap. The same applies to the July 2013s, actually slightly more so since the seasonal inflation pattern is more accommodating for that issue. So, if you’re buying short-dated Treasuries, I suspect you will be much better off buying those TIPS instead – they are far too negative on inflation, and remember: you get the “Middle Eastern crisis” option as well.