A tale of two reflations

We have seen a reasonably significant sell off in the majority of commodity markets over the past several weeks, particularly in the precious metals area. This sell off has been visited on the materials producers, as well as those areas inextricably linked to global growth. The downturn has been precipitated by discussions as to the possibility that the Fed will start to wind down its massive unconventional bond buying in the very near term.  What is curious is why equity markets have, for the most part, sloughed off this possibility when the majority of the liftoff in stocks since 2009 has been the result of global Central Bank activity. We have talked at length about how the various QE’s have had little impact on some of the physical markets that we follow, which would imply that money printing has little affect on real commercial activity. Having said that , if this activity were to cease, we really should see no real shift in real demand (not paper demand) for commodities. However, we would definitely see a response in the public capital markets as much of the 3 year tailwind has been Central Bank induced.  However,equity investors seem to imply that they can have it both ways. The market action in stocks seems to insinuate that a more hawkish Fed might hurt the economy, but that this damage will somehow not  migrate into the equity markets. We are highly suspect, as we always are, of any divergence between the reflation in paper (stocks) and the reflation in the real economy.

Please Yield

The recent lawsuit by prominent hedge fund investor David Einhorn highlights the struggle to prioritize corporate cash in a low rate/no rate world. Mr. Einhorn is imploring Apple to return some of its burgeoning cash stockpile to investors via a preferred dividend. His focus is to return some cash to investors via a significant dividend, but also to boost the value of the preferred shares as yield hungry investors presumably would bid up the shares above what would be a normal earnings multiple. Apple, for its part, has resisted such a proposal as it prefers to keep a comfortable stash of cash to maintain ultimate flexibility. This type of dynamic is currently being played out in the commodities world as well, as companies are being forced by shareholders and boards to shelve or severely cutback their highly aggressive growth plans. Quite frankly, the decision to hold cash at a tech company versus a mining company is quite similar.  Both are interested in growth, but only if that growth is additive.  Market history would suggest that the good times in neither tech nor mining coincided with bright decisions on the capex or acquisition front. However, if you think about it, they face similar fates if they fail to grow with tech companies simply becoming irrelevant, and mining companies risk becoming self liquidating entities as reserves dwindle.

Analysts at Citi recently wrote an excellent note on this point when describing the valuation of Rio Tinto. They stated that Rio Tinto traditionally has traded at a 30% discount to NPV. In essence, they maintain, for every $1 of NPV created by the company, shareholders have been rewarded with 70 cents of value. These analysts suggest that the market is essentially telling Rio Tinto that they do not allocate capital efficiently by not using the correct cost of capital. The thrust of the report therefore is that miners like Rio should use a much higher hurdle rate for projects than they have in the past, and if these rates cannot be met they should return cash to shareholders.

Paper Lion?

A recent study by Bain& Co. forecasts a “superabundance of capital” between now and 2020. Bain projects that there might be up to ten times the level of global financial assets relative to global GDP within the next several years. This divergence, driven by surpluses in Asia and the Middle East, should exacerbate bubble like behavior over the next 6-7 years the study reports. While we would normally ignore such drivel, it does make one think about all of the existing excess liquidity that exists today, and will most likely continue to exist going forward. The study assumes however, quite naively we might add, that this liquidity will flow mainly to public capital markets/financial assets. We maintain that smart capital seeking a home does not necessarily look only to traditional conduits of investment such as stocks and bonds but rather seeks out where it will be treated the best (return and safety). We highly doubt that the conditions which would warrant a sustained divergence between the real economy and the paper economy would be sustainable over any extended period of time.  Very recent history would suggest that negative real rates of interest have oftentimes caused excess liquidity to bleed over into areas of the real economy, sometimes in highly unpredictable and highly disruptive manners.

War Games

There has been an escalation of talk regarding the strength of ones domestic currency as of late, particularly among Euroland countries as well as Japan. It really boggles the mind to think that we have been engaged in these life or death struggles involving the Euro over the past year, only to hear the French President recently speak to an overvalued Euro. Similar talk has been emanating from Japan where a wildly overvalued Yen has been squarely targeted by the new Prime Minister as part of a package to target a significantly higher rate of inflation. As countries race to debase, it is quite telling what currency many investors favor: none. We have seen an almost insatiable appetite for physical gold, and not only among those countries like India where such holdings are culturally based.  Combine this demand, with the most recent decisions by certain Central Banks such as the Bundesbank, to bring home their overseas holdings of gold, and it would appear that the world is setting up for a protracted paper fight. This fight will not involve relative victories however, with all paper currencies coming down, albeit some much more than others.  In this war, the battle over paper will be ultimately won by those who own “stuff”.

Time is on our side, yes it is

When we lay out the legitimate case for hard assets versus financial assets, inevitably the questions arise as to the timing. Our response to these questions is always consistent: We don’t know. We have spoken at length about the futility involved in forecasting, particularly forecasting the onset of such a significant secular shift. However, the constant communication and information flow of today places pressure on investors ,which in turn, many times causes them to  overestimate their  own timing instincts. We point out to people, that more emphasis should be placed on where one wants to position themselves rather than exactly when.  The emphasis should be placed on the how and where rather than the when. We also stress to investors that the information flow regarding the beginning of this secular shift will be subtle and almost completely anecdotal. We can attest that these comments  offer little comfort for most investors, as they find it difficult to wrap their minds around such “soft data”. Investors are much more comfortable pointing to an event, or series of events, as evidence of a shifting investment paradigm.  We are firmly not in this camp however, instead suggesting that the divergence in returns and flows towards hard assets, and away from financial assets, will take place in a more nuanced fashion.

Tough Love

The comments by South African Mines Minister Susan Shabangu, in response to the most recent job cuts by Anglo Platinum are indicative of a shift in governmental resource oversight. Ms. Shabangu comments were as follows ” I see myself as a parent to the mining industry and when the children get out of hand, the parent has a responsibility of bringing the children in line” These comments are provocative in and of themselves, however they are even more so given that Amplats made their recent jobs decision based on escalating costs at the mines in question combined with relatively low platinum prices. If the threat of nationalization ranks among miners greatest concerns, then the prospects of turning ones mining assets into one big public works project must rank right up there as well. If private companies are not allowed to make economic decisions based on profit seeking motives, then governmental actions to quell such efforts can only be termed ” nationalization-lite”. If companies are not given the leeway to adjust production based on the current environment, then the only difference between these regulatory handcuffs and outright nationalization is who is responsible for the financing of the actual production.

Vaguely Familiar

Our declaration that hard assets will significantly outperform financial assets over the foreseeable future is purposefully vague, as to how to most optimally take advantage of this divergence. We hesitate to specifically point out investment targets because, quite frankly, we believe that the greatest returns will probably accrue to those areas which are currently overlooked.  While history is a good starting point when performing scenario analysis, the phrase “history does not repeat itself, but it does rhyme” should immediately spring to mind.  This mantra recognizes the similarity and dissimilarity, not only of markets but of market participants.  This becomes important when attempting to position oneself in anticipation of a particular forthcoming market environment. For example, the fact that gold has sometimes outperformed during periods of above average inflation does not necessarily mean that it will outperform some other physical metal which may have better underlying fundamentals.  Sometimes the structure that surrounds a particular asset is indicative of the degree of potential relative outperformance.  Perhaps, the fact that the individual investor has a number of ways to currently “play” the gold story is also a good indicator that the market might be simply revisiting their old inflation playbook.  Contrast this with some other smaller, non-exchange traded metals which essentially possess no speculative format which would allow investor participation. If we take as a given, the fact that all metals will benefit from an extended uptick in inflation, then the expected development of vehicles designed to allow investor involvement will only provide a tailwind for further price appreciation in some of the more obscure parts of the physical metals markets.

Between a rock and a hard place

The release of the December 11-12th Fed Minutes would indicate that the Fed is beginning to show some concerns about the heftiness of its own balance sheet. With the addition of the latest round of QE, the Fed is on target to grow its balance sheet by another $1 trillion over the next 12 months. The private concerns about the exit strategy with such a sizable inventory of bonds, does not jibe with the public commentary that surrounded the latest bond buying program. Perhaps the Fed is now torn between giving the markets and the economy (ostensibly) what it wants, and the realization that additional purchases mean additional unintended consequences.  The market reaction after the release of these minutes was perplexing to say the least, with equities selling off only slightly and commodity markets selling off sharply. If Fed purchases have, in fact, had little incremental impact on real economic activity then the cessation of these programs should have almost no impact on capital markets.  The impact will most likely be felt however during the unwinding of these purchases, which should adversely affect all markets.

Perhaps the Fed is attempting to manage peoples expectations as to the length and breadth of additional non-conventional measures. If this is the case, we should most likely get prepared for increased volatility as softer data intersperses with Hawkish Fedspeak. What this all means for commodity markets remains to be seen, but expect price action similar to that in 2012 as market participants navigate an increasingly conflicted Central Bank Environment.

The Great Enabler

In looking at our own fiscal impasse in the U.S., it made me compare and contrast this with the highly charged discussions that have taken place in Europe over the past several years. The only significant difference I can come up with is that the U.S. has the luxury of having unlimited access to domestic borrowing.  The whole self-imposed drama in the U.S. seems almost surreal as we read seemingly contradictory headlines like ” Dollar index reaches multi-week high as fiscal cliff seems unavoidable” or even more bizzare, ” Bonds rally strongly as both sides unwilling to compromise”. While Greece stared down the barrel of 30% short rates of interest and a forced promise to sell assets and affect real tax collection, the U.S. enjoys negative real rates of interest all the way out the Treasury curve. While it may seem unreasonable to compare southern Europe to the United States, the important point of comparison is discipline.  In the case of some southern european countries such as Italy, Spain, and Greece discipline is being meted out by the market participants who are demanding some level of fiscal discipline and austerity.  In the case of the United States, market participants themselves are being disciplined( or lulled) to believe that fiscal soundness does not matter as the captive buyer (Fed) will be there, regardless of what the infants in Washington hash out.

An important lesson of the last several years is that highly stable environments lay the groundwork for something highly unstable. By manipulating the entire U.S. Treasury curve, the Federal Reserve has been highly successful at maintaining an extremely low and stable rate environment. As a result, a multitude of strategies and structures have been built around the fact that rates will not be rising for several years. However, as we just discussed stability breeds instability. In a free market, low prices cure low prices and ultimately too low rates cure too low rates. However, in our lookingglass world, low rates are indicative only of a Fed constantly in “whatever it takes” mode.We wonder however, how much their activity would need to be ratcheted up in a market where they are not only the biggest game in town, but the only game in town.  In that not too unlikely scenario, look to buy stuff not paper.

Paper Chase

The SEC’s recent comments on a proposed copper- backed ETF shows the depth, or lack thereof, of regulatory analysis being applied to commodity based financial products. The staff of the SEC found that “Fund flows into ETF’s don’t lead to changes in underlying metals prices”.  They also went on to state that their analysis ” found no evidence of a statistical relationship between LME inventory levels and LME settlement prices for copper”.  The SEC analysis was performed on five ETF markets involving: Copper, Gold, Silver, Platinum and Palladium.  What was interesting was that they did not give the time frame that was used for purposes of correlation, but what was most interesting was that their basic analysis defies reality.  Perhaps a discussion with some actual metal producers might have led to some different conclusions.

Neville Nicolau, CEO of Anglo Platinum stated in 2011 that ” The investment sector is now firmly established as a key source for demand for the PGM’s with platinum investment making up 10% and palladium 15% of the 2010 demand respectively”.  A discussion with UC Rusal CEO Oleg Deripaska would have shed some light on this issue as well.  Mr. Deripaska wrote of the influence of investment flows into metals markets in an FT OP-ED piece in which he said ” Capital inflows driven by index investors and hedge funds in particular, have distorted the supply/demand equilibrium, sending the wrong signal for the players in the market”.

When the largest producers of metal are publicly commenting on the spillover affect that financial flows have on physical prices, one might think the SEC might take notice and dig deeper.  A more in-depth analysis however, would not serve the purposes of those seeking to bring more of these commodity- backed financial products to market.