Friday, 19th of February 2021
“Like Liberty, gold never stays where it is undervalued.”
– John S. Morrill
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Rates are rising in America, as long-dated treasury bonds in particular sell-off and investors rotate into riskier assets expected to benefit from the nascent economic recovery. This is causing the US sovereign curve, which plots the yields available on the most recently issued US government bonds of different maturities, to steepen – sharply. Last year, the US curve experienced its most acute steepening when the Fed cut policy rates to zero in Q1 and investors piled into short-term treasuries to benefit. However, the latest move only began in earnest after Pfizer released positive coronavirus vaccine trial results at the beginning of November, and Biden won a resounding victory in the US Presidential election. Since then, the 10Y and 30Y points are both up c.40bps. The government bond market moves (which have not been confined to the US) are linked to the rotation into cyclical and beaten-up areas of the market as optimism about the recovery from covid-19 takes hold. This is something we have spoken about in these pages many times, particularly in relation to equities. However, the critical factor affecting rate markets is a shift higher in inflation expectations.
There is scant evidence of inflationary pressure in the US (or elsewhere) at present. Indeed, the US core CPI reading for January was just 1.4% (YoY), which is well-below the Fed’s 2% target, unchanged from last month, and in line with expectations. This is hardly symptomatic of a runaway train. Moreover, although lockdowns and related restrictions have disrupted international trade and the supply of some goods (…just look at the cost of container shipping, which has skyrocketed in recent months), the huge demand shock from reduced business activity and household spending (particularly earlier in the year) has more than offset the price impact of supply constraints at the aggregate level. It seems clear that while demand is held back by coronavirus-related restrictions, soaring inflation is unlikely without the near-total collapse of supply chains or the dollar (neither of which is likely). But a more pressing question for us is what happens when the pandemic ends, and demand comes roaring back under ultra-loose monetary and fiscal conditions. Market prices reflect expectations about the future, and, as the vaccines are rolled out across the world, many investors are turning their attention to what comes next.
All data points to stimulus measures having had a big impact on the growth of the (M2) money supply, particularly in the US; at least according to the influential Quantity Theory of Money (a Milton Friedman special), this is all that matters in determining the level of inflation in the long run. Investors should take note because if inflation does take hold, this will herald a very different investment environment than that which has persisted over the last 30 years. Of course, many are sceptical that high (or moderate) inflation is coming down the line; for proof, these doubters need search no further than the 2008 Crisis, which was followed by an extended period of deflation despite some of the policy measures (e.g., QE) being similar to those in place today. However, this time round the fiscal stimulus has been much larger, ‘helicopter money’ has put cash straight into people’s pockets, and banks have been used to funnel soft loans directly to struggling firms. Quite simply, there was no equivalent expansion to the money supply in 2008-09. Perhaps even more importantly, no one is talking about austerity in the wake of the virus. A great green recovery (powered by state intervention and finance) is all the rage, while crisis measures will be very tough to wind down promptly. This suggests government spending will not fall back to pre-crisis levels anytime soon. Meanwhile, most central banks are very dovish these days. Clearly, the Fed and other central banks will seek to respond to any really dangerous rise in inflation through its usual open market operations and by raising rates. But if growth remains weak, they are likely to let inflation run hot before acting. The combination of a demand recovery, dovish central banks, expansionary fiscal policy, lasting supply constraints in some sectors (due to social distancing) and a spike in M2, point to inflation in the wake of covid-19. We are not forecasting a massive uptick, but moderate above-target inflation. And this has important implications for portfolios – creating multiple risks and opportunities.
One investment opportunity that we would like to highlight today is in commodities (which are used to hedge against inflation) and commodity equities (which are effectively a levered play on the former). To be sure, the commodities asset class is very diverse – and not all commodities are created equal. But the current environment is very supportive for many metals in our view. Long-end rates have been rising in recent months, and, together with diminished uncertainty and financial market volatility, this is having a negative impact on many precious metals. But rates across the curve remain very low by historical standards, and there are no signs that central banks are about to hike. Real rates can be thought of as the opportunity cost of holding commodities (none of which have cash flows themselves), and low real rates are naturally supportive for gold, and other cash replacements as a result. An episode of above-target inflation, therefore, which will reduce real rates by default, should make such commodities even more attractive than they are today. To be sure, economic uncertainty is fading somewhat, and this will reduce the appeal of gold to some extent. But the net effect of a reflationary growth spurt seems likely to be strongly positive for the yellow metal.
Other precious metals – which have uses beyond their cash-like properties – also look appealing in this environment. Silver surged in January when it briefly became the focus of retail investor activity, but it is still trading very cheaply relative to gold. In addition to benefiting from low rates, silver is an industrial metal (with industrial demand c.50% of the total). The metal is therefore geared into the economic recovery, unlike gold, while it is also used in photovoltaic cells so it should benefit from the secular growth of the sustainable economy. If you are positive on gold, the investment case for silver seems to be at least as compelling. Another industrial metal exposed to the immediate recovery and the expansion of the green economy is copper. The copper price sank during the early period of the pandemic in Q1, but it has bounced back strongly since then as construction demand picked up, fiscal stimulus buoyed the market, and vaccine optimism became a dominant force. In the long term, a great ‘electrification’ of the economy (from the spread of electric vehicles to the phasing out of gas heating by electric alternatives) to meet climate change targets suggests that there is a very strong case for the metal. For example, copper is used in nearly every major EV component (from the inverter to the wiring). Battery metals, from lithium to cobalt to nickel, are also likely to benefit from the same secular trends as copper. Supplying enough of these commodities to the market to meet rising demand could be tough. Indeed, Citigroup analysts have suggested that to reach Tesla’s 2030 production targets, the global lithium industry would have to expand eightfold …or prices will have to rise. In our view, therefore, metals seem like a great place to look for opportunities today. And the mining equities are a high beta way to get involved.
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