Guest post by Cantillon
In recent years it has become very fashionable amongst the want-to-be contrarian crowd to focus on the relative valuation of gold to other assets – particularly vs equities. There are clearly long swings of relative equity appreciation and then of relative gold appreciation – the latter being not terribly happy ones economically, socially, politically and geopolitically. The argument has been made that since in previous cycles the value of the Dow to Gold reached an extreme of 1.5 to 2, that this is a reasonable expectation for what can be achieved in the present or most recent cycle of relative Gold appreciation.
Possibly this may yet be proven right, but it is interesting to note that we have close-to-hysterical public sentiment regarding the perceived consequences for commodities of QE (the Glenn Beck special was really quite amazing, as has been the widespread public chatter over a supposed large dealer short in the precious metals) and objectively still-negative big picture sentiment towards equities (consumer confidence in the dumps, Obama approval rating very low with Osama bounce almost erased, net AAII relatively oversold, and a generally grumpy public mood).
Just today, I was struck by the FT publishing an admiring profile entitled “Angus Murray: believer in real assets”. Mr Murray is the CEO of a $500mm asset management company that offers a wide range of offerings including commodities, emerging market equities, and post-war art organized around a unifying thesis that a devaluation of money is under way, and that inflation is significantly understated based on the official data. He believes that in addition to the end of imported disinflation from the emerging world, the increase in the money supply seen in recent years will lead to acceleration in this devaluation of money from here. He recommends a portfolio of 40% emerging markets equities (since he is sure that returns will be poor on developed world equities) and 60% precious metals.
Now I do appreciate the evils of monetary inflation – I first read Milton Friedman and Hayek in 1989; have worked at the Cato Institute, where I read many books by the Supply Siders and journal contributions by the late 70s/early 80s advocates of restoring the gold standard; I persuaded Sir Samuel Brittan (then editor of the FT) to review David Glasner’s book on free banking in the FT; in summer 1999 I asked a member of the Austrian seminar at NYU if we were not at a moment very like in the 1920s (monetary inflation hidden by productivity growth and imported disinflation). And I have been a long-term commodities bull since shortly after I first heard Jim Rogers speak in London at the Institute for Economic Affairs on the launch of his first book. In summer 2003 I expressed very strongly to my boss, head of an investment company with substantial assets, that it was a momentous trade at that juncture to take the free money from the Fed and buy hard assets. So I do appreciate the longer-term arguments in favor of precious metals and against equities. I just don’t think making money in the markets is as easy as some otherwise very smart people seem to believe. Secular investment trends have a habit of expiring just when one is finally able to persuade a reasonable number of people of the merits of one’s argument and to be recognized for that.
To step back for a bit – the chart below shows what is easy to forget – that it’s really a paper asset vs commodities cycle: taking a view on stocks vs gold is similar to taking a view on stocks vs crude over the long run. Crude sentiment and positioning is extreme, and reading the media/bank research response to the selloff reveals astonishing complacency. Even my deflationist friends (“the US is like Japan, only much worse”) are bullish crude based on a supposed structural supply-demand imbalance. Reading notes of the recent Skybridge hedge fund conference – held one week after the silver crashlet - (with some heavy hitters incl Burbank, Steve Cohen and others) showed participants very worried about ‘black’ swans involving commodity prices taking off to the upside, but there was not one mention that prices could go significantly lower, let alone break Mar 2009 lows in some commodities with adverse consequences for more leveraged producers. The legendary Mark Fisher, author of the “Logical Trader” put forth what seemed to me to be a nonsensical argument: up till now there has been no fear premium; since there now is starting to be one, one ought to earn this by buying every dip or selling put spreads. At the risk of not paying sufficient respect to those more experienced, to me this shows a complete failure to grasp the intensity of the present mania for hard assets (and therefore scope for a substantial mess when it reverses).
Five factors come to mind that might lead to substantially weaker commodity prices on a 6mo – 2.5 yr horizon
- Falling resource intensity of Chinese growth – possibly we are quite far up the S curve of industrialization. Plenty left to go in other regions, of course.
- Slowing growth in the emerging world as lagged response to rate hikes and rising inflation in the developed world with tighter US policy – fiscal and monetary – leading to strong dollar.
- Unanticipated increase in supply from the Arab world, at least temporarily, as a consequence of the Arab Spring.
- Dawning realization that high commodity prices of past years have in fact led to large increase in supply (at least in some areas) – with a long lag. We mistook delay in supply response for no response. (Particularly significant with regards to Shale Oil, which by some estimates could lead to an increase in supply of 3mm odd barrels per day by 2015).
- Ebbing of inflationary psychology amongst producers, consumers, investors and speculators. Maybe people are just tired of being bullish.
If I am right about commodities, it’s hard to expect that Gold doesn’t also experience a substantial correction – although no doubt it would hold up a bit better than copper or crude.
Of course the other leg to the trade is that consumer confidence, consumer spending, job growth, credit growth and house prices are all at a juncture where much lower gas prices (up 50% from August low last year!) could kick start the next leg of the recovery and the next leg in an equity market rally.
(Since first drafting the above rather longer term take, I realize that I suppose I should include the brewing mess in Europe. No matter how much support core Europe can be persuaded to give to the periphery, there is no way for the periphery to recover competitiveness without maintaining very much lower inflation than the core for some years. And of course of late they have actually continued to experience inflation. Germany’s higher rate of growth in productivity simply makes the extent of the problem worse. So the only way we can possibly avoid an unraveling is with EUR/USD very much lower, and substantially higher German inflation over time. Once we get there, German exporters are likely to see a surge in profitability, since they are already profitable at the present high exchange rate. Of course wages are likely to grow under such circumstances and we should see rents and house prices rise also. I think the best case scenario is that we have a messy few months ahead for the periphery; and this isn’t by any means the most likely or only case. Weaker global growth, weaker risk appetite and a strengthening dollar would of course tend to hurt commodity-related plays much more than US equities).
I do not want to discuss it in much length at this juncture, but I am not sure that art – of whatever period – will be such a rewarding place to hide. In the old days, before art was considered a legitimate asset class, it was always the case that art and collectibles would perform very impressively just as the surge in liquidity was coming to an end. The boosters of this market suggest that things are different this time. I am not so sure.
Regarding breakeven inflation – that subject deserves an entire post of its own. But I think that the present focus on inflation is overcooked in the near-term. Stabilization in commodity prices will bring headline inflation back down closer to core. And if we do see commodity prices fall, as I expect, the current short-term panic that we see should ebb. I don’t think that changes the longer-term picture though that we are indeed early in a cycle of rising inflation (that began shortly after the tremendous outbreak of complacency and self-congratulation amongst central bankers as they recognized the ‘Great Moderation’). Even a horrible central banker can bring down inflation progressively over each cycle with little effort if imported goods are falling and there is a period of modest productivity growth at home; at the best of times, and in the best of cultures, it is much more challenging to decide to impose short-term pain in order to achieve a long-term benefit of low inflation and belief by people in price stability. Since World War Two we have grown rather accustomed to comfort, and I wonder how much suffering we will need to endure before we realize the cost of not recognizing what must be done and executing it rather than ignoring the painful aspect of the situation and hoping it will go away.
The point is that I think liquidity flows into asset prices early into an inflation. This is fun for the wealthy (who benefit from asset prices going up) and less so for the poor (who see their cost of living go up without a compensating increase in wealth). Later we may see a period that is less fun for everyone – assets go down, but the cost of living goes up.
Many of the ‘hard asset’ bulls seem to have forgotten that a rising cost of living does not imply hard assets go up in price – particularly if it is a rising nominal rate environment. There is a prevalent belief that assets and commodities will rise so long as real rates are negative and credit growth exceeds nominal GDP growth. There may be some truth to this over decades, but if one incurs the minor unpleasantness (discomfort again!) of getting hold of the data and studying it, it becomes evident very quickly that this belief is misplaced on a shorter-term horizon. Industrial commodities tend to peak (or at least experience their most positive phase) when credit growth is at its height. If credit growth falls, even if it is from say 30% to 20%, that is outright negative for commodities in the short run.
I do think that one buys the dip in breakeven inflation. This is a tremendous trading environment for people involved in these markets. Sadly it seems to me that many investors have a misplaced exposure to this asset class – for example holding inflation-linked bonds on an outright/unhedged basis. Not exactly the ideal trade in an environment of rising real rates!
Here is a picture of a long-term perspective on the Dow/Gold and Dow/Crude ratios – it shows very well my earlier point that hard asset bulls – even Gold bulls – are making a much bigger bet on industrial commodities (crude included) that they might realize.
Dow/Gold and Dow/Crude Ratios
With regard to the outlook for equities here – I do think that there are many US equities that are at attractive valuations and will perform well on a longer-term basis. Sentiment about the economy is very negative, and should improve if gasoline prices come down as I expect. But would prefer not to run a large outright long trading position in US stocks, given various risks I see to growth and to risk appetite in the shorter-term.