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Osbon Capital: Inflation Holdouts, Volatility, Relationship Driven Banking

June 10, 2022
Max Osbon

Inflation Holdouts

It's great to see some of the major commodity prices fall back to their all-time highs. Lumber is now below its pre-Covid all-time high. That doesn't mean Home Depot is going to give you a deal. Retailers are slow to pass on falling costs. Copper, wheat and corn remain elevated but not at all-time highs. Today's big underlying inflation holdout is energy, specifically oil and natural gas.

While most people seem to be aligned on the negative climate impact of oil and gas production and consumption, it's clearly not realistic to turn off production as early as we have. Supply shocks are hard to remedy. Renewables and nuclear generate 40% of US electricity, while natural gas generates 40% and coal the other 20%. Natural gas prices have quadrupled, and since we use electricity for literally everything we do, everything will be more expensive until natural gas prices come down. All markets are based on supply and demand and it's not easy to produce more natural gas on the fly, mechanically or politically.

The energy price problem has less to do with where we are going and more to do with today's reality. EV sales are multiplying, but adoption is still extremely low. Less than 2% of cars on the road are EVs. Biden has an executive order to ban all new combustion engine sales by 2035, but we all know how reliable executive orders are, and that's 12 long years away.

To sum this up: regardless of the pace of the clean energy transition, the world today is currently heavily reliant on diesel, natural gas, oil, gasoline, and other fossil fuel energy resources. Yes, these high prices put positive pressure on the adoption of renewables and nuclear, but that transition takes real patience. Yes, the trend points in favor of clean energy and away from fossil fuels, but that's not how the economy works at this very moment. In the meantime, we're unlikely to see lower prices until electricity prices come down. The Fed will keep trying to slow the economy until either supply increases or demand falls. For longer-term investors, it makes sense to invest in trends like nuclear, solar, EVs, lithium, and other core elements of our energy production. In the meantime, we are reliant on natural gas and oil. Those inflation holdouts need to break before we start seeing inflation come down. Axios has a nuanced article on energy production challenges and incentives if you are interested in reading more.

Private Market Volatility

The WSJ had a great story recently on the perceived benefits of investing in private equity. In short, when you invest in private funds, you don't have to stomach the continuous stock market swings. Investors in private funds typically commit to 7-10 year illiquid holding periods with prices marked to market every three months. In short, when you look at your portfolio of private equity holdings, you get the emotional benefit of muted and infrequent pricing. Like real estate investing, you can't close your position via a split-second decision to click the "sell" button.

There are other benefits to PE, too. Talented managers can produce great returns when they hit home runs, and leverage amplifies positive results. The same is true of real estate, VC, and public markets. After two significant public stock market declines in two short years, it's easy to see why investors prefer assets without daily CNBC prices or Dow point alerts on their phones. Of course, the antidote to this public market issue is to own quality assets with excellent management that will survive inevitable ups and downs and spare yourself the discomfort of checking your portfolio too often. The WSJ followed this article with a counterargument which you can read here.

Matt Levine's Comments On Automating Margin Enforcement

Crypto has entered a rough patch recently. On May 4th, I wrote, "In my opinion, these four projects are overvalued…They either need to decrease valuation or dramatically increase real user activity." referring to the leading alternative layer one blockchains Solana, Avalanche, Near and Algorand. These four crypto projects are down 40-60% over that short period. When liquidity ($USD) is scarce, young long-term speculative projects like these will not maintain all-time high prices.

This crypto bear market means topics other than price action get great coverage. Bloomberg Opinion writer Matt Levine covered an important ongoing discussion between leading crypto exchange FTX and the US commodities regulator CFTC.

"In some sense the entities of traditional finance are people and companies, and their counterparties can make credit decisions based on thick sets of information about them. Your bank can look at your credit report and payment history before giving you a credit card."
" it [crypto] is all sort of in the category of solvable math problems. No thick sorts of credit extension are required: The trading platform doesn't have to know where you live or have a good personal rapport with you; everything can be automated and done "on-chain," based solely on the blockchain's knowledge of your crypto wallet. In the traditional financial system, very few things work like this."

We've since learned that a major financial institution momentarily defaulted in the March 2020 Covid selloff, but was let off the hook. Crypto doesn't have to be the end-all-be-all solution, but its presence and competition push traditional finance to adopt crypto-inspired rules-based policies. FTX's margin trading, for example, checks for liquidations every 30 seconds 24/7, while conventional banks will let margin calls sit for days based on the quality of the relationship with the client. Sometimes that flexibility helps when prices recover quickly, and other times it dramatically accelerates risk for the banks, like in the case of Archegos.

People are understandably outraged by Wall St's track record of flexible rule-following. The Occupy Wall St movement focused on this unfairness, and clear repeatable rules will make the system robust. You can still give preferential terms to larger institutions while automated systems handle risk management decisions. This is entirely possible and not all that complicated, but finance is often the last to innovate.

Last year's Game Stop exploit was due to old systems used to track short-selling inventories based on a two-week cycle. That stale data led to more shares being sold short than existed. Clever people on Reddit's WSB figured this out first. Monopolies don't improve without competition - that's just a fact of nature. If we adopt more rules-based programmatic risk management in finance, it will force every participant to take the risk seriously, and the results will be more objectively fair. It doesn't matter if crypto succeeds because its presence introduces necessary competition to see improvements to underlying financial systems. Eventually, the best of both worlds will merge, and we will stop referring to traditional finance and crypto as separate industries.

A fun personal fact about Occupy Wall St is their poster of the ballerina on the bull is a picture of my wife Rachel. They photoshopped it without her knowledge or consent, but there's not much you can do once it goes up on T-shirts and posters.

Max Osbon
Partner / Owner at Osbon Capital Management