Decelerating tech momentum, slowing economic growth, declining consumer confidence, inflation, political rancor and flagging mental health are creating a socio-economic malaise that will undermine the efficiency and deflationary growth that has driven record equity prices for the last decade. This economic transition from a deflationary to an inflationary cycle correlates with the great rotation from growth and technology stocks toward cyclical, value and commodity stocks. This letter will outline the current economic and market environment and the attendant risks and opportunities that are likely to unfold.
Stagflation:
Signs of stagflation, which erode economic strength and undermine earnings, are ubiquitous. Stagflation, a term first used during the 1970s, describes both above average inflation and unemployment. Inflation hurts savers and underemployment reduces productivity. Both of these conditions will lower productivity and shrink profit margins, which will reduce hiring and investment in productive assets. Stagflation is the opposite of the technology-enhanced efficiency gains, which helped power the economy over the last decade.
In the second quarter, GDP growth was 6.7% and 2% in the third quarter. While the Delta Variant stifled growth, supply chain issues and the challenges of attracting new workers to unfilled vacancies are hurting economic growth prospects. At the same time, inflation which we had been told would be “transitory” and only slightly exceed 2% is running at 5% with commodity shortages and supply chain problems casting doubt on any inflationary reprieve in the near term. Stagflation is bad for stock and bond prices.
Inflation, Unemployment and Historic Bubbles:
The Pipeline Pressure chart below shows intermediate goods up 20% and at a 46 year high! Overall unemployment is shown on the chart to the right, which shows that true unemployment measures today can be as high as 8.5% and 22.8% depending on how one defines discouraged unemployed and under-employed people–and not just the 4.8% recorded by the Bureau of Labor Statistics.
Source: Bloomberg News, The Guardian and the BLS.
When bubbles burst, the ensuing decline can take decades from which to recover. GMO offers a sobering perspective on the losses that can occur from equity investing through the great bubbles of the last century. GMO shows that losses can take two or more decades to recover from the highs of bubbles like 1929, 2000 and the Japan bubble of 1989. Jeremy Grantham has a knack for capturing the risks associated with bubbles and how prudent long-term investment should be conducted.
Source: GMO
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Is Big Tech Cracking?
The parabolic rise in technology over the last 6 years has led us to believe that this rise in large-cap tech is a speculative bubble similar to the 2000 technology bubble, the 1929 bubble and the 1970 “nifty-fifty” bubble. There are historic cycles when certain types of companies or groups of companies become infected with an irrational exuberance that causes them to rise in a parabolic manner and then, when they stop rising, they endure multi-year declines.
The NASDAQ, since February 2016, has appreciated at 25.8714% annually. Historically, abnormally high rates reflected in parabolic price moves succumb to the law of large numbers or competition or new paradigms.
With the Facebook File revelations by Frances Haugen, growing tech lawsuits, anti-monopolistic pressures and increasing awareness of the negative psychologic effects of social media on children and society at large, a deceleration in big-cap technology momentum is increasingly likely. This past week, super mega-caps Amazon and Apple Inc saw disappointing earnings guidance suggesting their earnings momentum is decelerating.
The Great Rotation:
Below is a chart we have been tracking which shows the ratio of the CRB Commodity Index to the S&P 500 stock index. When this ratio is trending higher, commodities can outperform the S&P 500 by 800% and provide a compelling graphical representation when this commodity cycle engages, such as 1999 to 2008 and since March 2000. This chart ratio shows when portfolios should emphasize commodities and when they should emphasize growth and longer duration assets.
Source: Income Growth Advisors and Tradingview.com
The cyclical rotation we are presenting is synchronized with the economic inflation versus deflation chart below. The chart below shows the ratio of the S&P 500 divided by the Producer Price Index (PPI).
Source: Longtermtrends.net
After enjoying a fabulous few years investing in technology in the 1990s and exiting from the market at the top, our first-hand experience addressing the market challenges between 2000 and 2008 provide an experienced perspective on the importance of adjusting investment strategy to the new economic and market paradigm. If one continues to expect past investment performance to match future investment prospects in the Great Malaise, the 2020s may prove a costly and challenging environment.
Investment Strategy:
To successfully invest in the environment ahead, understanding which companies have pricing power and attractive margins is key to outperformance. We favor investing in companies whose rising costs can be passed onto customers and have pricing power.
We expect interest rates will rise due to the fact that rates are artificially depressed by central bank activities implemented to combat the Financial Crisis, the Great Recession and the COVID-19 collapse. The taper of the Federal Reserves’ monthly $120 billion in asset purchases will be announced shortly. The massive wall of liquidity, which has pushed the market to historic high prices, will soon lose one of its key pillars. In about one year, after the taper completes, the Federal Reserve should then begin tightening the Fed Funds Rate — a process that historically leads to a market correction. Markets should feel less ebullient during the taper and tightening even though earnings should continue to rise with economic growth.
Our strategy is to hold margin growth stories and emphasize commodity companies. Below are three equities we own and favor: Tellurian Inc. (TELL – NYSE), Antero Resources, Inc. (AR — NYSE), and Warrior Met Coal, Inc. (HCC — NYSE).
Tellurian Inc. (TELL) is a speculative next-generation international LNG distribution company. The company is looking to fund an LNG liquefaction facility in Louisiana, convert low-cost US natural gas into LNG and sell it abroad at significantly higher prices. The challenge will be funding the $12 billion Driftwood LNG facility; however, TELL’s Executive Chairman Charif Souki was the Co-Founder and Co-CEO of Cheniere Energy, Inc. (LNG – NYSE) a 26 billion dollar LNG exporter. Given Souki’s experience, the chance of him securing the needed financing given the structural shortfall in global LNG capacity appears favorable. TELL is moving to the NYSE on Tuesday and we expect to see a baby bond sale and the announcement of a natural gas asset purchase in Louisiana in the coming weeks. TELL’s ability to supply its own low-cost natural gas and then sell it internationally provides a means for directly capitalizing on the spread differential, which makes TELL potentially more lucrative than Cheniere, but also riskier.
Antero Resources, Inc. (AR) we have owned for over a year for our clients. AR is a well-managed natural gas E&P run by two talented former Lehman investment bankers Paul M. Rady, Chairman and CEO and Michael N. Kennedy, CFO. During the COVID-19 and energy collapse bottom in 2020, several Wall Street analysts feared that Antero Resources would go bankrupt; however, we viewed the company’s open market purchases of AR stock and bonds a strong sign that bankruptcy was not likely. AR has risen from $1/share to $20/share and credit William Travis Koldus for writing about AR as a “generational investment opportunity.”
This week AR reported earnings and it appears to be a powerful pure-play natural gas company with still more upside to be realized. The chart below from the company conference call was highly compelling.
The chart shows the cash flow recovery from the point where the company was losing money in 2018 and 2019, turned profitable in 2020 and stands to generate $900 million in cash flow in 2021. More impressive is the forecast that AR will generate $6 billion in cash flow over the five-year period from 2021 to 2025 and an average of $1.2 billion in cash flow a year for 5 years. Given the fact that AR has a market capitalization of $6.23 billion, AR is trading at an attractive 5 times multiple of cash flow for a powerful high growth pure natural gas play on the Utica Marcellus shales.
The slide below also shows that AR has the highest free cash flow yield to enterprise value of any natural gas company among its Appalachian peers. AR continues to use free cash flow to pay down its debt and will trade at 1x free cash flow to debt in q1 2022.
The bottom line is: AR looks like a solid winner in the natural gas space and the company could rise to $50-60/per share in the coming years. AR is highly leveraged to natural gas and will experience pullbacks when natural gas prices correct.
Warrior Met Coal, Inc. (HCC) is an Alabama-based specialty coal company whose metallurgical coal is critical for producing high-quality steel. With the economy recovering and reopening demand in building, infrastructure and car manufacturing, demand for metallurgical coal should remain strong. Historically, met coal stocks are high beta plays on the steel industry and HCC is a special situation. HCC has two Alabama mines now selling their top-grade coal at $400/ton price. Given that when we first read about the stock and the company trading at one-time cash flow, coal prices were $125/ton at the time, the valuation case looks far more compelling today.
In addition to the coal price improving their earnings prospects, HCC has had an active strike that should get negotiated to a resolution. The company clearly is now in a position to pay higher wages and this strike has dragged on longer than expected. When the strike settles, earnings prospects will improve because the company will no longer be labor-constrained.
HCC will report its earnings this Tuesday on November 2nd.
Bonds, Bond Equivalents and Income:
Interest rates are artificially depressed and the yield curve will normalize over the next 2-3 years. During this inflationary cycle, we advise reducing bond maturities to five years or less. We would invest in floating-rate securities and cash to manage duration risk. Additionally, we have been building positions in MLPs to get an attractive tax-advantaged income which will enjoy some inflation hedging attributes as MLPs are correlated with oil prices.
Two income securities we like are Antero Midstream Inc. (AM – NYSE) and GAMCO Global Gold and Natural Resources & Income Trust (GGN – NYSE) a closed-end fund that invests in gold and natural resources.
Antero Midstream Inc. is the midstream component of AR – Antero Resources, Inc.
AM yields 8.4% and should pay down debt and be positioned to raise its dividend in the next few years with surplus cash flows. AM is benefitting from the strong natural gas market, a world-class management team, strong cash flows, and prime shale exposure in the Utica and Marcellus.
GGN yields 9.28% and enhances its income through a covered writing portfolio strategy. With its exposure to gold and energy, combined with its attractive monthly income, GGN offers a vehicle for above-average income during a period when energy and gold prices should rise.
Conclusion:
The macro-economic dynamics that have defined investment returns for the past decade are changing from deflationary to inflationary. While we do not know how high-interest rates or inflation will rise, there will be a decided change in the market due to the new inflationary environment and investment strategy will need to change.
The negative impact of higher interest rates, flagging unemployment, social media enhanced divisiveness, higher taxes, government overreach and political rancor in the wake of the COVID-19 pandemic, are creating an environment we are dubbing the Great Malaise. Portfolio strategy will need to be rethought to find companies that will flourish in a rising interest rate or inflationary environment. This new investment paradigm is juxtaposed with the high growth deflationary backdrop of the last decade that has propelled large-cap tech and the S&P 500 to record prices and valuations.
Please check our website for our recent teach-in on this investment paradigm transition held on October 15 and for an article we wrote for Seeking Alpha on Tellurian Inc.
Happy Thanksgiving,
We welcome your thoughts and comments at this dangerous time.
Sincerely,
Tyson Halsey