The August 2020 Federal Reserve Jackson Hole meeting produced a generational shift in monetary policy in which the central bank abandoned its staunch 40 year inflation-fighting posture. Income Growth Advisors, LLC (IGA) has been warning of higher interest rates, since then, and 10-year US Treasury yields have been rising, except during the recent month’s Delta Variant induced economic pause. Since the Jackson Hole meeting, Federal Reserve Chairman Jerome Powell and its Board of Governors have been pitching the idea that the economy can tolerate higher inflation and that that inflation will be transitory. IGA believes that inflation will be higher for longer and inflation over the 2% transitory target will not quickly reverse. And this inflation will lead to higher interest rates and lower stock and bond prices. Inflation is increasingly manifesting itself, and treating it as transitory appears to be a policy error that is unfolding daily. Inflation is a regressive tax that will hurt mid and lower-income earners and will risk significantly raising the US debt servicing cost of our $28 trillion debt and inflation’s consequence will have a real impact on all asset class prices.
How Rising Rates Hurt Equity Valuations:
The only compelling valuation case for today’s historically high-priced equity market is the Federal Reserve Model or Risk Premium Model which compares interest rates with the earnings yield of stocks. If interest rates begin to rise above expectations, then stock prices will decline. If inflation drives meaningfully higher interest rates, stock prices will become perilous.
The chart below is of the Federal Reserve Risk Premium Model. It shows the S&P 500 has soared to new highs with the cyclical rebound in earnings expectations which are tied to the economy’s recovery from the pandemic.
A Brief Pandemic Market History:
The data set below shows various key periods from before the pandemic and up until today. Before the pandemic stocks were fully valued and the 10-year US Treasury Note yielded 1.87%. With the spread of COVID-19 and the initial March 2020 stock market panic, the S&P declined over 34% in five weeks. This stock market decline created a tremendous buying opportunity IGA highlighted when the Risk Premium rose to 6.29% – a level comparable with the 2008-9 financial panic bottom. With the ensuing economic “recession”, 10-year Treasury yields declined to 0.5% in August of 2020, when prospects for a vaccine solution started gaining traction. The subsequent powerful economic and market recovery has driven stock prices to new highs. With the emergence of the Delta Variant in March 2021, the economic recovery slowed, bond yields dropped from 1.73% to 1.15%, and technology stocks outperformed. With the Delta Variant spread now reversing nationally, the economic recovery is reengaging and cyclical or reopening stocks are recovering.
The Dot Plot:
The Federal Reserve’s Dot Plot shows the central bankers’ expectations for Fed Fund rates in the years ahead. Historically, 10-year Treasury Note yields are 0-2% higher than Fed Fund rates. The Dot Plot chart below shows the Fed Fund currently at 0.25% and it is forecasted to rise to 1.5% by 2024. 10-year Treasury Note yields should rise toward 3.5% in the coming years. The Fed will soon commence reducing financial accommodation through open market financial purchases of $120 billion/month of treasuries and mortgages. This reduction in Federal Reserve purchases is known as tapering or “the taper.” Once the taper concludes, assuming continued economic strength, the Fed will start raising Fed Fund rates or tightening. Historically, when the Fed begins tightening, the stock market becomes vulnerable to sharp declines or bear market declines of 20% or more. The concerning fact is inflation exceeding the Fed’s expectations and the timing of the Fed’s taper and tightening are coming more rapidly than the Federal Reserve had envisioned.
An accommodative Fed is the market’s friend. The artificially and incredibly low interest rates which helped the economy and markets to recover from the Financial Crisis and the COVID-19 crisis are now going to be taken away. The speed with which the Fed is now revising their planned accommodation reversal demonstrates that the benign transitory inflation thesis is being debunked. This combination of high stock valuations and the Fed’s accommodation reversal telegraphs increased market volatility as was manifested in September’s S&P 500’s down 4.76% performance.
Below is a chart of the Federal Reserve’s dot plot:
Source: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20210922.pdf
Inflation Expectations:
Inflation is rising and is being driven by several factors. Supply chain problems drive inflation as a lack of product availability has led to soaring prices. As a result of the pandemic, supply chain issues have worsened with China as the relationship between China and the US has deteriorated. China is having internal energy issues. Semiconductor shortages are holding up car manufacturing. Ports like Los Angeles have ships backed up and unable to unload container cargos due to truck driver shortages. These delivery problems will raise product costs and add to producer and consumer prices.
The chart below on the left shows that intermediate goods prices are up 20% on a year-over-year basis, a level not seen since the 1970s. The chart below on the right shows that GDP expectations are moderating after peaking in the second quarter. The widely watched PCE inflation and Core PCE are rising even while the US economy’s robust momentum is decelerating. Higher inflation and lower growth are an ominous combination for earnings and stock prices.
Source: Bloomberg Wall Street Week, the Bureau of Labor Statistics. CNBC.
Commodities:
Higher commodity prices add to inflation. Commodity prices have been rising and are up about 50% this year. The chart below of the DBC ETF which mirrors the Chicago Research Bureau “CRB” index shows commodity prices pushing higher. Additionally, real estate prices are rising and the rent equivalent costs will soon be added to inflation data. Inflation from rent equivalent costs tend to be sticky, unlike commodity prices which are cyclical. We anticipate more persistent bad news on inflation. Further, wage gains are also sticky. The current labor shortage will further add to inflation as employers are unable to fill job vacancies.
Source: Interactive Brokers Trade Station and chart of the DBC Invesco DB Commodity Index tracker ETF.
The Great Rotation/Reflation Chart:
Since 2018, IGA has been highlighting the chart below which shows the ratio of the Goldman Sachs Commodity Index (GSCI)/S&P Index ratio. The chart captures multi-year market cycles when commodities out-perform relative to the S&P 500. When the economy is in a deflationary environment, bonds and stocks rally relative to commodity prices and this index declines. When commodity prices are rising faster than the S&P 500, the chart ratio starts moving up. In May of 2020 when oil price futures traded at negative prices, a commodity cycle low was established. During reflationary or inflationary cycles, commodities can out-perform the S&P 500 by as much as 800%. We believe that May 2020 was the beginning of a multi-year trend where investors will find better returns in commodity-linked securities than the S&P 500. Today we are seeing a reflationary economic environment and we are in the foothills of a secular transformation into an inflationary/reflationary economic environment.
Commodity Cyclical Investments:
Representative commodity cyclical stocks IGA owns for its clients to capture this rotation include Antero Midstream, Inc. (AM), Antero Resources, Inc. (AR), United States Steel Corporation (X), Cleveland-Cliffs Inc. (CLF) and gold stocks. Two aggressive smaller high return opportunities we like are Tellurian, Inc (TELL) and Warrior Met Coal, Inc. (HCC).
Below is the one-year chart of Tellurian, Inc.
Tellurian, Inc. is led by its renowned Co-Founder and Executive Chairman, Charif Souki. Souki, who formerly was the Co-Founder and Co-CEO of LNG giant Cheniere Energy, Inc. (LNG), is building his second natural gas production and liquefaction company which will take low-cost abundant US natural gas (Henry Hub nat. gas is $5/mmBtu), condense it into LNG, and then sell it internationally where LNG sells for $20-25/mmBtu. With the cost to process and ship being approximately $2.5/mmBtu, the spread is enormously profitable. While the spreads represent spot prices and not long-term contracts, securing the financing for a $12 billion liquefaction facility is a risk. But it is a risk worth considering since Souki is a proven LNG developer, investment banker and entrepreneur. Morgan Stanley recently published a research note forecasting a $22/per share price target on successful FID (Final Investment Decision) in mid-2022. From today’s $3.96/share price, this is a high risk high return asymmetric proposition. Given Souki’s legendary reputation in the LNG space and someone who has helped create 17% of the global LNG market, Souki could be a CEO worth betting on. Further natural gas and LNG are leading the clean energy transition. Coal is being replaced with natural gas and natural gas will fill the world’s energy needs over the next two decades until renewables will scale enough to provide a meaningful contribution.
Below is the one-year chart of Warrior Met Coal, Inc.
Source: Interactive Brokers Trader Workstation
Warrior Met Coal, Inc. (HCC) is a small highly leveraged commodity play. HCC is a small Alabama metallurgical coal operator with unique ownership of two mines with some of the finest met coal in the world. With met coal prices soaring Warrior’s market capitalization could be exceeded by its cash flow according to KCI Research in the quarters ahead. Stocks trading below 1 times cash flow are extraordinary bargains. In addition, metallurgical coal is a critical component in the manufacturing of high-quality steel. As the economy recovers and steel production ramps up, especially when the semiconductor shortage stops hindering car production, HCC could see a significant move and possible special cash dividend.
Cyclical Comparables and Market Prospects:
In the 1970s, inflation rose when commodity prices increased fiercely. Oil prices, due to the OPEC embargo, rose from $22/bbl in May 1973 to $59/bbl by February 1974 and ended the decade near $130/bbl in April of 1980. During this period, interest rates soared, and the stock market tanked. Fortunes were made in oil and silver and other commodities in the 1970s. Money deployed in the S&P 500 from May 1973 to April 1980 did poorly. The S&P 500 was 107.20 in May 1973 and it declined to 103.00 by April of 1980. The only return an investor earned from the S&P 500 during that decade-long period was its dividend. During the same period, yields on the 10-year US Treasury rose from 6.85% to 10.4%. While we do not expect an oil embargo and a quintupling in oil prices, we expect commodity-sensitive securities will be one of the best areas to invest in the years ahead.
Another comparable inflationary cycle period to consider is from 1999 to 2008. Oil prices rose from a low of $18.71/bbl in November 1998 to $175/bbl in June of 2008. The S&P rose from 1,144.43 in November 1998 to 1,341.25 in June 2008, a paltry return. 10-year US Treasury yields declined modestly from 4.83% to 4.10% offering a modest 4% total return primarily from their coupon.
IGA believes that traditional asset allocation strategies based on historical returns like the 60% equity/ 40% bonds allocation will prove disappointing if not disastrous if the great rotation and reflation trade fully engages. However, a more commodity-centric and lower duration strategy could lead to significant outperformance if the next decade resembles the 1998-2008 or 1970s periods.
Short Term Market Prospects:
With the rapid decline in COVID-19 cases and Merck’s recently announce potential blockbuster therapeutic to treat COVID-19 infected patients, the road to full recovery appears to be accelerating. So in spite of our cautious longer-term prognosis, the stock market may experience a rally in October recouping some of its September losses; however, the critical fundamental factors which will determine market performance will be inflation and interest rates. Interest rates are artificially depressed, the economy is recovering, inflation is accelerating, and interest rates will certainly rise in the coming weeks and months.
Conclusion:
We are in a historic asset bubble. Stocks, bonds, and real estate are overvalued as a result of the artificially low interest rates which have been engineered by the Federal Reserve and Central Banks around the world. Due to the combination of the post-pandemic recovery and the rebirth of inflation, interest rates will rise. Higher interest rates will be a headwind for stocks, bonds, and real estate, and there will be a sea change to the investment public’s mindset because interest rates have been declining since September 1981 when 10-year US Treasuries yielded 15.32%. Since then, fortunes have been built investing in real estate, bonds, and stocks leading most investors to believe that they will continue to compound their historic investment returns and their wealth accumulation. Unfortunately, those backward-looking investors may face a rude awakening in their wealth accumulation and their lifestyles will dramatically change.
During the years ahead, if inflation drives higher interest rates, the great rotation will deliver fantastic returns for those investors who have studied past reflationary periods. We believe great financial rewards will come from rotating to inflationary cyclical stocks and commodities which will broadly outperform traditional interest rate sensitive asset classes like stocks, bonds, and real estate.
Sincerely,
Tyson Halsey, CFA