With inflation hitting 40-year highs, interest rates are rising rapidly toward normal historical levels. With accelerating urgency, the Federal Reserve, the U.S. central bank, is communicating that it will be rapidly raising rates in the months and quarters ahead. The Fed’s new policy marks an end to a forty-year era of declining interest rates. These artificially low rates have propelled asset bubble valuations such as in equities with mantras like “TINA” aka “there is no alternative”. Unfortunately, despite the sharp declines markets experienced in April and year-to-date, today’s inflationary cycle could last a decade. Historic, economic, and valuation precedents also suggest this inflation cycle could drive secular bear markets in stocks, bonds, and real estate.
This letter will analyze this inflation cycle and its impacts. We will highlight investment ideas that can capitalize on this new inflation normal. Although interest rates have risen sharply from their pandemic-related trough, today’s spiraling inflation, exacerbated by the war in Ukraine and an emerging cold war with Russia and China, rates will likely rise much further in the years ahead. Let’s look at the commodity supercycle which is driving a multiyear rotation from stocks and bonds toward commodity beneficiaries.
Commodity Cycle Charts:
The chart below shows the ratio of the S&P 500 to the CRB index. When the ratio is rising, commodity prices are rising faster than the S&P 500. This last happened between 1998 and 2010. Due to well-intended but poorly managed energy transition policies, the world has found itself short on energy. Putin is using this as a weapon in his war with Ukraine. Due to the hasty cancellation of nuclear power and the defunding of most fossil fuel capital investment, US consumers are experiencing a sharp inflation in energy costs. Inflation effectively is a regressive tax. For the 3.5 billion people living in less developed countries, they are disproportionately suffering due to inflation and the overly optimistic expectation that solar and wind can seamlessly replace traditional fossil fuel resources.
The commodity super cycle bottomed in May 2020 when oil traded at negative $37/bbl in the futures market. It has accelerated with the February 24 Russian invasion of Ukraine. The invasion of Ukraine has made energy pivotal to global economies’ prospects. Further, the invasion has made energy a military weapon and a critical energy security factor to the distress of many climate activists. These charts show that both the trend of inflation and a commodity super cycle is strengthening.
Historic Inflation and Deflation Cycles:
The chart below shows the ratio of the S&P 500 to the Producer Price Index (PPI). Since 1971, inflationary cycles and commodity supercycles tend to last about 10 years. Because the type of assets which appreciate during an inflationary cycle are distinctly different than those assets which appreciate during a deflationary cycle, it is important to understand these cycle trends and durations. Furthermore, an inflation oriented portfolio strategy today will provide a vastly different set of investment options and a distinctly different portfolio strategy than what has worked well for investors for the last 40 years.
Capital Rotation Cycle:
A key driver of the commodity cycle is the capital rotation cycle. For new projects to be built in the energy space, the economics of the projects must be compelling enough to entice capital to invest in a new project. Higher prices increase project returns. If oil stays at $100/bbl or surges to $200/bbl, projects globally will get funded and new supply will come onto the market. These new supplies will drive lower energy prices. A fracking project takes about one year to get to first production. Deep water oil projects like those in the Gulf of Mexico or the North Sea take seven years until first production. Consequently, rising energy prices are likely to last at least one year and may take five years to “bend the curve.”
Energy is just one component in today’s challenging inflationary environment. The evolving supply chain issue will continue to add to inflationary pressures. Initially, the US economy had supply chain issues with the COVID pandemic. With the emerging cold war with Russia and China, more supply chain issues will develop, and it will take years to replace those supply chains from China and energy supplies from Russia. Consequently, inflation will be far more persistent than most realize and could remain elevated above 2% for five or more years. This will be a devastating hit to US consumer’s purchasing power, and even more consequential to the less economically privileged global citizenry.
The chart below shows how capital investment follows commodity prices. The declining price of oil from 2014 to 2020 led to a reduction in US energy capital expenditures. This particular cap ex decline was also exacerbated by ESG activism which led to wholesale liquidation of energy investments to satisfy ESG mandates from public and private investment pools. While ESG and the goal of decarbonization is logical and laudable, indiscriminate and forced ESG liquidations have created the current costly predicament many are trying to transition through. Furthermore, the top UN Sustainability goal is to end poverty, and today’s spiking energy prices are having the opposite effect. ESG currently is a regressive tax on the world’s poor and poorest countries.
Stopping Inflation Through Fed Tightening:
The Taylor Rule and the basic economic theory I learned at Duke University in the early 1980s suggests that the Federal Reserve must raise interest rates above the inflation rate to curb inflation. With the PPI notching an 11.2% annualized rate in April, the Fed is way behind the ball in taming inflation. For this reason, the peak interest rate in the quarters and years ahead may be far higher than most investors realize.
Equity Market Valuations:
Equity markets have been buoyed by artificially low interest rates since the Greenspan “put” was created in the late 1980s and 1990s. Since then, markets have repeatedly been bailed out by the Federal Reserve by providing exceptionally low interest rates in response to every crisis. With the financial crisis of 2008-2009, the Federal Reserve commenced a period of unprecedented central bank accommodation. With the Fed fund rate around 0.25% and $9 trillion in assets on the Federal Reserve’s balance sheet, we believe rates could rise to 5% on both the Fed Funds and 10-year US Treasury yields in the years ahead. Since interest bearing investments are the primary investment alternative to equities, a hawkish and persistent Fed could weigh heavily against equity prices.
The Risk Premium or Fed Model offers a quantitative framework for estimating future prices for the S&P 500. The Fed Model Risk Premium chart series below shows the Risk Premium which allows analysts to measure equity values in comparison to the 10-year US Treasury yield. Today’s Risk Premium is 2.47%. When the Risk Premium is positive, the model suggests that stocks are worth the incremental investment risk compared to the yield of the 10-year US Treasury. Today’s Risk Premium means that the 10-year US Treasury yield could rise to 5% without creating a market crash. However, these numbers are guidelines and not absolute. The risk premium troughed in early 2000 at -2.4% before the historic Tech Bubble peak. In March of 2020, we wrote that the stock market was in a stage of “irrational negativity” and at that time, the Risk Premium was 6.29%, the highest level since the Financial Crisis bottom in 2009.
Furthermore, the Risk Premium does not look at the investment environment. It does not reflect the rapidly slowing economy, 40 year high inflation, nor a potential world war. We believe the S&P 500 could decline 45% over the next three years, though the Fed could raise rates enough to stop inflation and create a soft landing.
Investment Ideas in the Energy Transition:
While global industries seek to reduce harmful emissions from their operations and create greener energy options, substituting high carbon fuels like coal and oil with lower carbon fuels like natural gas and liquefied natural gas (LNG) is one of the most efficient large scale approaches for the energy transition. By providing critical energy to drive global growth while reducing carbon emissions providers of natural gas and LNG are among the most compelling investment themes of the inflation beneficiaries we have researched. For this reason, our clients have been investors in Antero Resources Corporation (AR), the fifth largest natural gas producer in the US. Likewise, Tellurian is positioned to be a leading LNG exporter and is playing an important role in helping the Biden Administration deliver 50 BCF of LNG annually to Europe.
This past week, Antero Resources Corporation reported compelling earnings. AR, located in the gas rich Utica and Marcellus shales, is the second largest natural gas liquids and fifth largest natural gas producer in the United States. AR is run by two former Lehman energy investment bankers who adroitly navigated the natural gas bear market from 2008 to 2020. Since spring of 2020, AR has been retiring debt and buying back stock. AR stock has soared from $1/share, when some worried about the company’s solvency, to $35/share today as an emerging powerhouse. AR’s market capitalization is $10.9 billion and should generate $10 billion in cash flow through 2026. The company expects to generate $2.5 billion in cash flow this year and again in 2023.
AR’s first quarter was particularly illuminating. Mid-quarter, after completing its planned debt repurchases, the company engaged its share buyback program. With the spiking natural gas prices due to Russia’s invasion of Ukraine, the company bought $100 million in stock at an average price of $27.11/share. As the company pays down more debt this year, AR stated that intends to increase its share buybacks to 50% of cash flow from 25%. These purchases benefited from high natural gas and LNG prices. Shrewdly, the company has created a positive feedback loop that accelerates its debt and equity retirements by reducing its interest expense and its share count.
Tellurian Inc. the LNG liquefaction and export company led by Executive Chairman Charif Souki the former Co-Founder and Co-CEO of Cheniere Energy, Inc. (LNG), is making clear strides toward funding its Driftwood LNG facility near Lake Charles, Louisiana. Construction on the facility by Bechtel commenced in early April. On March 24, the Biden administration announced a plan to ship 50 billion cubic meters of LNG annually to Europe. TELL with a $2.5 billion market capitalization appears to be a logical beneficiary of this deal which is designed to help Europe’s transition away from Russian natural gas. Within a week of the Ukraine invasion, German Chancellor Olaf Schulz announced Germany was stopping the Nord Stream 2 pipeline from Russia, sending arms to Ukraine, and building two LNG import facilities. TELL, which is putting final touches on financing Driftwood, is a logical immediate beneficiary of this agreement as Europe seeks to break its reliance on Russia natural gas.
We estimate that upon the announcement of the Driftwood final investment decision or “FID”, TELL stock could rise to $8-12/share from its current $5/share price. Furthermore, TELL could rise to $15-20/share by year end. Our optimism is based on TELL’s experienced management and TELL’s new business model which provides more operating leverage than Cheniere Energy, Inc. (LNG). LNG’s market capitalization is $35 billion.
Today’s 40 year high inflation changes everything. Inflation is driving higher interest rates and interest rates impact asset valuations. The end of a 40 year period of declining interest rates changes key assumptions for portfolio strategies and investment decision making.
Unfortunately, investment behaviors change slowly. Today’s new inflation normal and commodity super cycle will not easily be stopped. Widely adopted investment constructs like the 60/40 stock bond strategy should underperform while commodity price beneficiaries could see 700-800% outperformance relative to the S&P 500 over the next decade. Bonds, in the years ahead, will likely underperform and no longer provide purchasing power parity.
The S&P 500 could decline 45% over the coming years and long duration bonds could also perform poorly. These returns provide a grim prospect, but the Federal Reserve and US economy could produce a soft landing leading to merely subpar performance. We are advising downside risk mitigation. This is a critical time to think and invest differently.