A Rude Awakening

For the first time since the 1970s the sense of fiat currency erosion relative to financial assets and consumer prices due to misguided policies has penetrated the mindset of investors in a significant way. Global monetary debasement is now setting the stage for a rude awakening. The inflation genie is out of the bottle and policy makers are unable to sustainably ease off the liquidity pedal. Financial repression has become essential to secure the health of the economy at the current levels of overall debt. Nonetheless, easy and cheap access to capital has also been one of the key reasons for the historical disconnection between asset prices and fundamentals. In fact, the sheer amount of financial assets today that trade at near record multiples is truly concerning.?Preventing a collapse in risky assets has become a true policy constraint for monetary authorities.?Different than other times in history, the Fed’s ability to allow the cost capital to substantially rise is incredibly limited.?Ultimately, policy makers have their hands tied and will be forced to counter deflationary pressures in financial assets with further liquidity. Igniting an inflationary environment is the path of least resistance.

To use the US stock market as an example, the 5-year cyclically adjusted earnings yield is now near all-time lows. In other words, investors are undeservedly paying excessive prices relative to bottom-line fundamentals.?Going back over a century of historical data, such depressed earnings’ yields have always led to very significant market meltdowns: the Great Depression, the 1937-8 Recession, and the 2000 Tech Bubble. For every one of these periods, the market unexpectedly reversed from very bullish multi-year trends with an average subsequent 3-year performance of -53%.

In the five years leading up to the Great Depression, markets were up about 30% in annualized terms. After the crash started, markets suffered for three years straight with an annualized decline of about 54%. In 1932, stocks finally bottomed, and we saw a five-year streak of 36% annualized return. By March of 1937, the equity market reached historically overvalued price levels relative to depressed corporate fundamentals and the macro environment made a 180-degree shift again. From 1937 to 1942, stocks suffered a 60% drawdown. The 2000 bubble was no different. In a similar manner, the US equity market was performing exceptionally well leading right up until the bust.

As we have shown, today’s stock market is more overvalued than those other three times by a variety of metrics. In this context, it is hard to believe that the Fed will be able to sustainably reduce its monetary stimulus without triggering potential market meltdown issues.

Naturally, as different opportunities present themselves over time, market positioning and capital allocation tend to change drastically every five years or so causing major reversal trends. We strongly believe investors are poised to experience another one of these significant market rotations where capital allocation moves away from historically expensive equities to then find its way into cheap tangible assets, i.e. commodities.

The Elephant in the Room: Low Interest Rates

Now let’s address the elephant in room. You would think that a low interest rate environment would be positive for stocks, but that is far from the truth. The problem is that inflation is running much higher than interest rates. When we look at valuations of equities versus 10-year real yields in the last 120 years, equity fundamental multiples significantly compressed when real yields were negative for a long period of time. To be fair, however, this is the first time we have seen negative 10-year real rates with valuations at historic levels.?An incredibly important takeaway, commodities performed exceptionally well during the three highlighted times below.

From the Government to the People

On the other hand, we believe inflation will continue to surprise to the upside in the following years. One major reason for that is the chart below. The combination of Fed stimulus to finance historical amounts of government spending has led to one of the largest wealth transfers in history. Interestingly, since the Global Financial Crisis, the increase in government debt has been directly linked to the increase in net worth of the US population. One important difference from prior years, however, is that fiscal policies are increasingly becoming more focused on the bottom 50%.

The Four Main Fronts of the US Fiscal Agenda

The US fiscal deficit problem has somewhat improved since March of this year, which was the worst level in 70-years. Relative to nominal GDP, the fiscal deficit now stands at -12%, which is about 6 percentage points better than its prior lows at -18.5%. The issue is that this number still is 2 percentage points lower than the worst levels reached during the Global Financial Crisis. The US government is determined to pursue a fiscal agenda that has four main fronts:

• The Green Revolution:?the financial efforts to attempt curbing the effects of climate change have become a major priority of the current political leadership. We are seeing big steps towards regulating carbon dioxide emissions and reducing fossil energy production and exploration. Meanwhile, the government remains focused on incentivizing renewable energy technologies and electrification as part of a transition to a modern and sustainable energy.
• An Infrastructure Revamp:?bipartisan policy makers believe the economy necessitates major improvements in roads, bridges, airports, ports, electrical grids, green initiatives, etc.
• Peak Inequality:?policies targeted towards narrowing the wealth spread between the lower classes and the richer parts of the society appear to be at the forefront of the Biden administration’s policy stance. Some examples would be their efforts towards cancelation of student loans, the increase of minimum wages, hiking corporate taxes, etc. As part of this, we have recently seen a 27% increase in food stamps, the largest one in history. This process of wealth transfer from the rich and the government to the bottom 50% of the population is only getting started.
• A Fiscal Arms Race with China:?Biden and his team have kept a very hawkish stance against China. The prior administration approached their concerns by imposing tariffs on Chinese imported products. This administration wants to tackle this differently by subsidizing domestic companies in strategic industries to be able to compete with Chinese businesses.?

It is hard to believe that with such an ambitious agenda government spending will not remain aggressive going forward. We think fiscal deficits will continue to run at double-digits for the next years. The issue, however, is that in addition to the extreme levels of government stimulus, the US trade balance is already turning significantly lower and likely to continue to deteriorate.?

Structural Inflationary Pressure Building Up

For the last four decades, cyclical increases in inflationary forces have been short lived. Aside from a steady downward trend in money velocity, one of the key reasons why inflation has not yet grown more sustainably is due to a secular decline in wage and salary growth since the late 1970s. However, among one of our highest conviction ideas, we believe we are experiencing the beginning of a structural shift in the growth of workers’ remuneration. Most investors have been paying close attention to the wage growth tracker by the Atlanta Fed which continues to show very muted changes since the pandemic started. The issue with this index is that it applies a sample of only 60,000 households or less than 0.04% of the total amount of employed Americans. We think the most accurate calculation is to look at the wages and salaries aggregate number divided by the number of employed persons. Our own measurement is now growing by 14% on a 24-month basis. Similar to what Americans experienced in the early 60s to the late 70s, we think we are at the very beginning of an upward inflection in wages and salaries.

The Macro Opportunity on the Long Side of the Market

What we view as particularly exciting in the current macro environment is the commodities market. In our analysis, the natural resource industries have turned into remarkably profitable businesses in the last several quarters. Aside from the coal industry, we view the entire segment as an attractive investable opportunity. The aggregate free-cash-flow now generated by commodity producers is growing at a pace we have not seen in the last 30 years. In the table below, we provided six different fundamental metrics for commodity producers with a market capitalization above $1 billion in the Canadian and US stock exchanges by breaking them down into five industries. Precious metals’ companies were clearly the most attractive on a growth, balance sheet strength, valuation, and quality basis. Aside from the strong bottom-line growth and relatively high free-cash-yield, the margins for gold and silver companies are significantly better than the other commodity producers. Although natural resource companies are capital intensive businesses, precious metals’ producers have a much cleaner balance sheet profile than the others. Oil and gas companies, on the other hand, appear to be the cheapest on a free-cash-flow yield basis but are also significantly more levered. Base metals’ stocks performed well recently and therefore show better growth but worse value metrics. In our funds, we favor a larger exposure to gold and silver companies as we remain highly convicted that the underlying monetary metals will benefit the most from the current macro environment. We have a sizeable position in base metals and also hold energy and agricultural companies in our large cap strategy.

Early Innings in the Precious Metals Cycle

Among some of the important metrics to analyze how early we are in the precious metals cycle is the level of merger and acquisition activity in the industry. As shown in the chart below, the M&A cycle has not even started yet. Senior miners have become true free-cash-flow machines at these metal prices. We have not seen this level of net cash accumulation in a long time, setting up a flood gate of liquidity for the following years. In our view, it is just a matter of time before major producers look for high-quality exploration companies as acquisition candidates.