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.

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.

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.