By: Jim Brilliant, CFA® Chief Financial Officer, Co-Chief Investment Officer, Portfolio Manager, Principal.
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The economy, interest rates, inflation and stock market valuations have all changed dramatically in a very short period, which we highlight below followed by questions and answers about this historic environment:
- We’ve gone from a period where the Fed was injecting record stimulus into the economy to a Fed that today is aggressively raising rates and reducing money supply.
- We’ve gone from record low interest rates two years ago when the fed funds rate was at 0% and the 10-year Treasury bond was yielding less than 0.7%, to much higher interest rates today with the fed funds rate at 4.0% and the 10-year Treasury bonds yielding roughly 4%.
- We’ve gone from a period of inflation being consistently less than 2% to today’s Core CPI inflation at a 40-year high of 6.3%.
- Energy prices, food prices and transportation prices are all up significantly.
- Wages are increasing, but in many instances not enough to compensate for the increase in inflation.
- We’ve moved from decades of rapid trade globalization to de-globalization and trade wars.
- As for markets, from March 20, 2020, (the low during COVID) to a high on January 3, 2022, the S&P 500 Index increased 113%, only to decline 17.70% by October 31st. The tech-heavy NASDAQ, increased 134% from its COVID low in March 2020, only to decline 29.77% year-to-date through October 31, 2022. This time around, even bonds have not provided a haven from market volatility. Year-to-date through October 31, 2022, the Bloomberg Barclays Aggregate Bond Index declined 15.72%. (Note, the performance of these indices includes dividends and interest.)
Question: What’s causing the volatility in interest rates, commodities, and asset prices? Is inflation transitory?
While there are many moving parts, we believe the root cause of what seems like a dramatic change of events really began two decades ago.
In December 2001, China became a member of the World Trade Organization (“WTO”). China’s membership was not only championed by both parties in Washington, but celebrated as a big win for the United States and the European Union. The hope was that bringing China into the WTO would expand world trade for US and European companies, as well as bring capitalism and democracy to China. This shortsighted thinking by the West allowed very lenient trade terms with China.
China’s entrance into the WTO initially led to a huge infrastructure build throughout China, creating a massive demand for commodities, pressuring world supply and pushing prices higher. From the time China entered the WTO in December 2001 until the world economies collapsed in the great recession of 2008, spot oil prices increased 7 times from $20 per barrel to $145 per barrel, natural gas prices increased 4.5 times, the price of copper increased 5.6 times, and the S&P Goldman Sachs Commodity Index increased 5 times. This surge in commodity prices contributed to the CPI inflation index increasing from 1.6% in December 2001 to a peak of 5.6% in July 2008.
In response to higher prices and supply deficits, the global metal mining industry increased capital expenditures (“capex”) from an average of $20 billion annually in 2000, to $140 billion by 2012. During the same period, global exploration and production capex for oil and gas expanded from less than $200 billion annually to over $700 billion. This huge capex wave eventually brought a significant additional supply of commodities to the market, albeit with a long lag.
At the same time, a tsunami of companies began outsourcing manufacturing to China. For US companies, once China was in the WTO, it was as much an opportunity to lower cost as it was a necessity to compete in the Chinese market. Initially, this was viewed somewhat positively because the deflationary impact of offshoring labor to China partially offset the rising commodity inflation caused by China’s industrialization. US companies also saw benefits of selling their products into a huge new market.
Question: Are you saying that the last commodity cycle that lasted from 2000 to 2012 was caused by China’s industrialization and that led to inflation rising from 1.6% to 5.6% in 2008?
Yes, this was the primary factor. When China entered the WTO, the world had not fully anticipated the additional demand China would have on commodities. The additional demand dramatically outstripped supply, pushing prices higher. The industry responded by adding significant capacity, eliminating the supply shortages, and ultimately reducing the elevated prices. Of course, it takes time to turn capital spending into real production.
Question: Then we had the 2008 recession; what impact did this have?
The 2008 recession, the ensuing housing crash and the related financial crisis had widespread impacts. In response to the rising inflationary pressures during 2007 and 2008 and the wild speculation in the housing market, the Fed began aggressively raising rates to cool the economy and slow inflation. By failing to identify the supply-side capacity shortages as the root cause of inflation, the Fed aggressively raised rates, setting off a sequence of events that resulted in a housing crash, a banking crisis, widespread bankruptcies, and the deepest recession since the Great Depression.
In response to the imploding economy, the Fed created new tools to ward off a depression. It opened the printing press and flooded the banking system with dollars, while at the same time significantly tightening bank lending requirements. By flooding the banking system with dollars, the Fed effectively offset the massive asset deflation, while limiting bank lending, forcing banks to strengthen their balance sheets. Ordinarily, the Fed’s printing press would have caused rapid inflation. However, several deflationary forces were at play, effectively offsetting the Fed’s printing.
First, much of the Fed’s printing remained captured in the banking system, helping banks strengthen their balance sheets, while neutralizing the inflationary pressures of printing.
Second, consumers who were reeling from the collapse in asset values and declining wages reduced spending and took the next decade to repair their finances.
Third, US companies continued to outsource manufacturing to China, exporting labor cost and importing cheaper goods.
Finally, the 2008 recession hit demand, while an influx of new supply from the previous cycle’s huge capex programs hit the market. In turn, commodity prices collapsed as supply deficits of the past cycle flipped to abundance.
All told, these events set up a period from 2010 through 2019 of slow economic growth, low inflation (below 2%), very low interest rates, and high asset valuations. In fact, deflation became the biggest concern during this period, leading to negative interest rates in Europe and 0% fed funds rates in the US.
Question: How did we go from deflation to inflation? Why does the history matter, and how is it connected to today's inflation?
Think of it as a pendulum that swung way too far in one direction. When it swings back, it doesn’t stop in the middle.
In response to the COVID pandemic, the Fed pulled out the same tools it developed during the Great Recession, once again flooding the economy with money through quantitative easing, just like it did post-2009, but on steroids! Only this time the banks’ balance sheets were in much better shape, so instead of the Fed’s printing staying on the balance sheets of banks, it went directly to businesses and into consumers’ pockets. Importantly, this meant the Fed’s printing was not neutralized as it was post-2009.
Consumers spent the previous decade improving their financial position and were in much better shape going into the pandemic. The extra money from stimulus checks and reduced spending during lockdowns further improved consumers’ balance sheets and purchasing power.
Around 2015, outsourcing manufacturing to China became less advantageous for US companies due to higher Chinese labor costs, trade sanctions, shipping bottle necks, and intellectual property theft becoming more prevalent. As a result, US companies began the process of reshoring manufacturing back to the US, which increased demand for US labor. In 2019, just prior to the pandemic, unemployment was at a record low of 3.6% with wages rising.
Perhaps most misunderstood is the state of the commodity markets. After having added significant capacity to meet rising demand for China’s industrialization, commodity prices collapsed from their peak in 2008. This resulted in declining cashflows and increased bankruptcies across the entire commodity complex (energy, agriculture, metals, etc.). As a result, for the past decade, capital spending has been declining for nearly all commodities. This underinvestment in commodities meant new sources of supply also declined, while demand has remained strong. Today, we are once again facing supply deficits just as we did when China began industrializing.
This time, however, in addition to already low inventories across the full suite of commodities, we are facing rising supply deficits and capacity constraints. Historically, this would be a signal for the capex and investment cycle to start ramping up. Unfortunately, with the scars of huge losses and widespread industry bankruptcies over the past decade fresh in their memories, very few commodity companies have been adding capacity. In our opinion, we believe all these factors suggest commodity prices will remain elevated for many years to come.
Taking a closer look at oil, the world has never faced the capacity constraint we have today. Global spare capacity is only about 1 to 2 million barrels per day. Over the next 12 months, we believe it’s likely that demand will not only exceed supply, but also exceed global production capacity. This will likely result in higher oil and gasoline prices for many years to come.
Naturally, higher prices should result in substitution, where consumers choose a cheaper alternative. Electric vehicles (EV’s) are, of course, what the world is pointing to as the alternative to replace oil (gasoline) demand. However, there are not nearly enough rare earth minerals readily available to build all the batteries needed to make a meaningful impact, nor is there sufficient electrical grid capacity to power a widespread move to electrification. Therefore, widespread substitution, as it relates to combustion engine cars and trucks, is not likely to happen any time soon.
In fact, battery metals themselves face supply deficits and tight inventories, requiring a long, difficult, and expensive investment cycle, not to mention the often-overlooked environmental issues that will continue to increase costs. If electric vehicles are ever going to replace the internal combustion auto fleet, significant improvements to the existing technology will be required. In other words, all forms of energy are supply constrained. It’s a fallacy to think renewable energy alternatives can meaningfully, quickly, and cheaply replace fossil fuels. The bottom line is the world is in an energy crisis and more of ALL forms of energy are needed.
Question: How does the government debt impact the inflation outlook?
In the 106 years from 1900 through 2006, just prior to the debt-funded bailouts of the financial system caused by the Great Recession, the Federal government accumulated $8.9 trillion in debt, which includes the funding of two World Wars, the Great Depression, the New Deal, the Korean War, the Space Race, the Vietnam War, decades of war in the Middle East and 22 recessions. From 2007 to 2019, after just one recession, the US government added another $13.5 trillion in debt. Now consider in the last 3 years alone, the government added another $8.4 trillion in debt, nearly equal to the total debt accumulated over the 106 years from 1900 to 2006. Further, over the past 15 years, the federal debt has increased over $21.9 trillion. Currently, government debt stands at a record $31 trillion, which equates to 123% of GDP - double the 62% debt of GDP in 2006!
There is no free lunch, even for the government, which must pay interest on its debt. In 2006, with total debt of $8.9 trillion, total interest paid was $408 billion for a weighted average interest cost of 4.53%. In 2022, total debt exploded to $31 trillion (i.e., an increase of 248% from 2006), and interest cost is estimated to be $625 billion (i.e., an increase of 53% from 2006) for a weighted average interest cost of just over 2.0%. Clearly, the government benefited from the low interest rate environment of the past decade. However, those days are gone as inflationary pressures have driven interest rates higher for all maturities. Currently, the weighted average maturity of government debt is approximately 6 years. As this debt matures and new debt is issued at incrementally higher interest rates, the cost of debt service will rise. The current interest rates on Treasury bonds maturing over the next 2 years to 30 years range between 3.9% and 4.5%.
Consequently, over the next decade, the cost of financing the current $31 trillion of debt is likely to double from the historically low 2.0% interest rate to something closer to 4.0%. Additionally, for the past 20 years, total government debt grew at an average of 8% per year. If we calculate that the debt balance grows at the same 8.0% per annum over the next decade and interest on that debt is 4.0%, then by 2032 the total US debt will stand at $66 trillion. The interest expense will equal $2.7 trillion, or 4.3x the current level.
To put this in perspective, it’s important to consider total gross interest cost relative to total government revenue. According to the Congressional Budget Office (CBO), total US government revenue is roughly $4.9 trillion, a historically high 19.6% of US nominal GDP. If nominal GDP grows at the CBO’s projected 4.4% rate over the next decade, and if government revenues remain at the historically high 19.6% of nominal GDP for the next decade, then total government revenues will grow from $4.9 trillion to $7.61 trillion by 2032. With gross interest expense on pace to grow to $2.7 trillion by 2032 (as shown above), it would equal 35% of 2032 revenues, becoming by far the largest expense of the federal budget and thus crowding out other government programs. Can you say Banana Republic?
Incremental interest expense will produce ever bigger deficits, resulting in what is referred to as a doom loop – a cycle where rising interest cost creates bigger deficits, requiring more debt, resulting in bigger interest expense, even larger deficits, and considerably more debt. This is clearly not a sustainable outcome and weighs heavily on the Fed to contain inflation while not sending us into a deep recession, which begets more fiscal and monetary stimulus, creating a larger deficit, and requiring higher debt levels. This would negatively impact the dollar, ultimately leading to even more inflation.
Focusing on inflation, we believe the Fed’s recent action of aggressively raising interest rates to slow demand should eventually reduce the headline inflation…somewhat. In other words, the higher rates will slow consumer demand and allow supply chains to catch up, and reduce some inflationary pressures. However, we do not believe the Fed’s actions to slow demand will meaningfully improve the global energy supply scarcity. Talk of recession along with higher interest rates only serves to further push out meaningful capital spending programs by energy and mining companies, which is sorely needed to add necessary production capacity and additional supply to the market.
Currently, it’s our belief the Fed understands the tough spot it is in. We believe the Fed will continue to pursue rate increases and talk tough to contain inflation. As inflation begins to decline, the Fed will likely back off to prevent a recession. The current target for the fed funds rate is 4.6%, but we suspect it will be forced to move rates up and down over a multi-year period due to the underlying twin structural inflationary pressures of labor and energy shortages, likely keeping inflation well above the Fed’s 2.0% target for many years.
Question: So where are we in the market and how should we structure the portfolio?
- Overall, we believe the market will continue to experience multiple compression (i.e., downward pressure on P/E multiples) with many companies facing margin pressure. Already, the forward P/E on the S&P 500 Index has declined from 27.4x on September 2, 2020, to 17.8x as of November 17, 2022.
- With that said, technically speaking, we could continue to see a bear market rally over the next month or two, and we believe it could be upwards of 10%. We will continue to evaluate our holdings and will trim or sell any position if we deem it appropriate.
- Depending on each individual client’s cash weighting, we may invest a portion in 30, 60, 90, and 120-day US Treasury bills as part of our cash management.
- Importantly, if we do have a bear market rally, we believe the next leg down could be 15% to 25% lower than where the market is priced today. This type of volatility could last several years and likely include a period of recessionary inflation. This is typically referred to as stagflation, where inflation is high or rising, economic growth slows, and unemployment increases.
- We continue to favor commodity companies, especially those in the oil and gas sector, as we believe there are structural supply and capacity issues to contend with that will likely be around for the next three-to-five years, which should be very supportive of energy prices.
- We believe most energy companies in our portfolios are trading as if West Texas Intermediate (WTI) crude is priced in the $60 to $70 range versus ~$82 today, and as if natural gas were at is $3 to $3.50 per btu versus the ~$6.2 price today.
- Many of the energy companies in our portfolios are paying solid dividends, including some with yields exceeding 5.0%. In addition, many of these energy companies are selling between 4 to 6.5 times cash flow, compared to the S&P 500 Index selling at roughly 13.2 times cash flow. Additionally, with their current free cash flow generation, most energy companies in our portfolios have rapidly improved their balance sheets and are buying back shares, which in turn increases shareholder value.
- We believe the energy sector offers some of the best values in the market today. However, this goes beyond just oil and gas. We are also actively looking at uranium and lithium companies, or those companies that service the production of these commodities as well. The truth of the matter is the world will need all the energy that can be produced from all sources.
- We believe having exposure to gold, silver, and copper is important. Currently, we favor owning the physical precious metals through ETF’s over mining companies. However, we may also begin investing in the mining companies as they move into our value zone.
- We also believe the de-globalization of trade between the democracies of the West and autocracies of China and Russia will lead to continued reshoring of industrial and technology manufacturing capacity back to North America. This will support investments in supply chain localization, factory automation, and continued strength in factory wages. Industrial technology companies should be prime beneficiaries from these trends.
- During this past quarter, we increased our cash position and believe we will see some great opportunities to reinvest these proceeds sooner than later.
- For clients with balanced accounts, we are finally seeing corporate credit spreads widen over Treasury bonds, thus providing us the opportunity to start buying 2-to-3-year corporate bonds that yield 4.5% to 6%. For most of these bonds, our intention is to hold them to maturity, reinvesting the proceeds as rate spreads fluctuate.
As for the market at-large, we believe it is digesting the continued increase in interest rates. The Fed has made it quite clear at its recent press conference that it intends to raise the fed funds rate to 4.4% to 5%, and it expects to get real rates (i.e., after inflation) to a positive 1%. In other words, the Fed wants the fed funds rate to be 1% above the core inflation rate.
Historically, interest rates along the yield curve (i.e., the full length of short-term and long-term bond maturities) flatten near the peak. This suggests that the current 10-year and 30-year bond yields need to move higher to flatten the curve near the 4.4% to 5% expected fed funds rate. This means these bonds must drop in price so their coupons represent a higher yield. Additionally, as intended by the Fed, the increase in interest rates will slow the economy, reducing earnings and valuation multiples for many companies. We are well positioned to take advantage of the opportunities we see ahead.
We believe we have a strong portfolio based on fundamentals, and it is our belief that fundamentals win out over time. The table below shows the valuation metrics of the stocks in our average investment portfolio versus the S&P 500 Index as of November 16, 2022.
As you can see below, in every category, this table suggests our portfolio has materially more imbedded value versus the Index. What this table also suggests is that if P/E ratios and other valuation metrics decline, the S&P 500 Index has much more to fall to get into a value zone than our average portfolio. Historically, value stocks do better than growth stocks during times of higher inflation, and we believe this time will be no different.
To conclude, we believe that while inflation will fluctuate, it will remain higher and be more persistent than most expect. Our study of historical inflationary environments shows that the best performing asset classes, sectors, and individual equities tend to be commodities and commodity-related companies, including those in oil, gas, metals, precious metals, and agriculture, as all significantly outperformed the S&P 500 in the periods of study. To put it into perspective, during the inflation of the 1970s’s (from 1972 to 1980), an equally weighted commodity index returned 21.55% annually compared to the S&P Index of only 2.0% annually during the same period.
In the current environment, the world faces severe and chronic supply shortages of these same commodities, potentially adding even more weight to the historical outperformance of this group during inflationary periods. Additionally, during periods of higher interest rates and inflation, value stocks generally outperform growth stocks.
We have structured our portfolios to include equities in the areas that we expect will benefit from inflation, while also maintaining our value discipline. It is our goal to not only provide positive absolute returns, but to also protect purchasing power during the inflationary period we see ahead.
Disclosures: Century Management ("CM") is an independently registered investment adviser with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Century Management is also registered as a Portfolio Manager in the Province of Ontario. Century Management reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. Forward-looking statements are not guaranteed. Past performance is not indicative of future results. The discussions, outlook and viewpoints featured are not intended to be investment advice and do not take into account specific client investment objectives. Positions held within each individual account may not be the same from one account to the next. Individual securities may be traded at different times as well as receive different execution prices. In addition, individual accounts may be pursuing similar objectives but may have different investment restrictions. A full description of our Firm’s business practices, including our Firm’s investment management services, wealth plans and advisory fees, are supplied in our Form ADV Part 2A and/or Form CRS. Investment in equities and fixed income securities are subject to investment risks, including, without limitation, market risk, interest rate risk, management style risk, business risk, sector risk, small-cap risk, liquidity risk, prepayment risk, extension risk, among other risks related to equity and fixed income securities. CM-22-03