Gold, US Dollar, and the First Hint of Reflation

Key Takeaways

• The US market is still following the same Fed and Government stimulus narrative of the last months, which end ups benefitting the larger and already dominant companies of the US equity market (#tech).

• Despite a non-eventful month, gold is up 20% since June and has now reached nominal all-time highs. We wonder if this finally signals a potential return to inflation? Early to say, but definitely interesting to follow.

• Moreover, the US Dollar had the worst-sell off in July since September 2010, US Tech continues to decrease competition in the market, US companies are raising record cash amounts and corporate executives are now net sellers of equity.

Prologue

“In the very big picture, however, I think the macro equity investor still needs to ask this question when they first open their eyes in the morning: do I want to fight the Fed today or do I want to follow the Fed today?  My point is there’s an ongoing tailwind from the Fed — which is more subtle than it was in April, but is still very significant; it’s not crazy to think that QE could be upwards of $4bn per business day for another few years [for context, Amazon is expected to generate close to $1bn of revenue per day]. In the end, I think that argues for ongoing support to tech multiples, while of course understanding that there will be ebbs and flows along that path.”

 Tony Pasquariello, Goldman’s global head of Hedge Fund sales

The activity in financial markets since our last markets report, especially on the equity side, reminds me of a saying we tend to use in Portugal: “Os cães ladram e a caravana passa”, something that can be translated to The dogs bark and the caravan still carries on (if there’s any professional translator in the audience, please forgive the heresy). The caravan is an objectification of the financial markets (sponsored by the Fed) and the dogs are the people who populate our Twitter feed. Since last month, we’ve seen some noticeable price action in the market, especially in US Tech, Gold and the US dollar, but the main narrative is still broadly the same as the previous month. Markets are up, tech is the main beneficiary, multiples are crazy expensive and yields continue to be utterly depressed (US 10y yield is below 0.6% now, compared to almost 2% at the beginning of the year).

Source: Wall Street Journal

As we normalize into this new system of masks and recurrent hand sanitizing, paranoid about the barely noticeable cough of the guy sitting next to us (he’s embarrassed about it, as well, so give him a slack) but still wanting to live our summers, we would argue that there’s so much occupying our mind space at the present moment that many of us have left the “keeping up to date with the financial markets” habit on the side for the past weeks.

Realistically, there are solid arguments for doing that: it’s a distorted market, one that doesn’t represent the real economy, one that only goes up until the “day of reckoning” comes with the promise of washing out all the excesses (the erotic dream of many hedge fund managers at this point), bringing down multiples and once again enabling active managers to generate alpha with their routine of research and price discovery. It’s a market that, by historical standards, is not intellectually stimulating. Yes, there are still some pockets of opportunities to be the smartest ones in the room, but even for short-sellers like the one and only Jim Chanos, who apparently just banked $100mn on his Wirecard short, the current market is “a really fertile field for people to play fast and loose with the truth, and for corporate wrongdoers to get away with it for a long time”, meaning that integrity and analysis-based price discovery is really challenging at the present moment.

There seems to be little room for the equity story, for the “undervalued” companies who are turning around their businesses and are worthy of our trust, for exploiting the opportunity that “the market is missing”. No wonder our generation is moving away from finance. But as Millennials with deep interest in markets who, despite having studied past cycles, have only been able to participate in a “distorted” one, we find little need to blindly advocate for a reversion to the mean or for the comeback of value investing, as that was never a reality for us. This certainly makes us naïve, but with that we also avoid being tribalistic and are forced to focus on objectively trying to understand what’s actually going on, as opposed to what we thought should be going on. We’re beginning to believe that the best investment managers right now are those humble individuals who acknowledge technological progress, who understand that market structure can and has indeed changed, and who do not discredit the younger generation’s interest for passive investment and alternative assets. But that’s just us.

US Tech Equity Bubble

The world’s equity market has gone nowhere since 2015, whilst US tech has risen five-fold. We believe we’re in a US Tech bubble, but not a global equity bubble.

Louis-Vincent Gave has written an excellent article on the current US Tech bubble, where he frames the idea that US Tech has actually become the scarce asset that investors are driven to given their natural monopolistic tendencies, which leads to less competition, higher pricing power and continued profit growth. And whilst this might optically seem non-sensical as one would argue that technology is everything but “scarce”, he points out that this is not the first time we’re seeing this dynamic:

“Back in the Keynesian period of the late 1960s and early 1970s, investors flocked into what were then called the “nifty fifty” stocks. Back then, the prevailing view was that only large multinationals could deliver growth and reap the harvest of coming globalization. As a result, the excess money pumped into the system pushed the valuations of “scarce” multinationals ever higher. Or it did until 1973, when oil prices spiked, and all of a sudden investors were forced to reassess what was scarce (oil) and what wasn’t (cross-border production and distribution capacity).

Investors have long ago forgotten about the nifty fifty. Instead, today we have the nifty five—Facebook, Apple, Amazon, Microsoft and Google. What could be scarcer than a duopoly in online advertising? Or a hold on a major chunk of the fast-growing cloud computing business? Or a worldwide retail base, fuelled by solid knowledge of your individual customers? Or a tech ecosystem that keeps its users locked in and buying hardware products at prices far above those charged by any other producer?”

Whilst tech is the gift that keeps on giving (similarly to Instagram accounts like @litquidity), what catalysts could we expect to bring the current US tech rally to an end?

1. The Fed begins tightening its monetary policy. Currently, this seems to be a low-probability event, especially after Q2 US GDP declined 32.9% (nearly 5x the Q4 2008 record decline of 7.2%). Not to mention US unemployment is still at 11.6% and is probably being understated (#ReadOurMacroPrint).

2. The US Government tightens regulation. Whilst the risk of this is evident and many have been advocating for it for a while now (#ProfG), it will likely still take some time before any regulations are actually passed. in the meanwhile, evidence that we’re destroying competition is becoming more and more apparent now.

1. The Herfindahl Index is a measure to keep track of how concentrated a market or an industry is (the higher the index, the more concentrated the market is, meaning that there’s less competition). This is one of the reasons why companies like Facebook, Amazon, Apple or Alphabet had a six hours Zoom exchange with Congress recently. The Antitrust hearings of the House Judiciary Committee should be seen as one of the most important new developments of the Millennial generation, but the likelyhood of it halting the current rally seems far fetched at this stage.

2. US Tech slows down its growth. These companies have grown sales at such speed that currently they own a very significant portion of the markets they operate in (e-commerce, advertising, cloud services, etc). For them to keep up the current rate of growth, they’ll need to look for new business opportunities elsewhere, and failure to deliver on those might prove that US Tech’s growth levels isn’t this scarce, after all. Pairing a top-line slowdown with the potential return of beaten down value opportunities and the roaring comeback of commodities, and investors may be finally presented with alternative capital allocation opportunities beyond the Nifty Five.

As such, if there is to be any downside risk to US Tech, what is the potential magnitude of the move? John P. Hussman has a run some math:

“Presently, the largest 5 stocks in the S&P 500 comprise about 23% of the market capitalization of the index, easily eclipsing the 2000 peak, when the big 5 represented just over 16% of index capitalization. Here’s the thing. Investors now require these stocks to maintain their current market share, relative to the index as a whole.

Consider a bear market that brings valuations only to 2002 levels – the highest level of valuation observed at the end of any market cycle. If the S&P 500 was to decline by 50% overall, and the largest 5 stocks moved back to the 2000 extreme of 16% of the index (which they represented as recently as 2019), the implied loss for these stocks would be 0.5(.16/.23)-1 = -65%, while the implied loss for the rest of the S&P 500 would be 0.5(.84/.77)-1 = -45%. That’s not so much a projection as an implication of arithmetic, so we should at least consider this possibility given that the market cap of the largest 5 stocks has become unusually skewed.”

Gold’s Recent Rally to a nominal all-time high

Gold is up 20 % since the beginning of June and is now hovering above $2,000/ounce (Diego 2 – Tim 0). Silver has recently caught up on the rally too. If you’re thinking about proposing, you better do it sooner rather than later, or maybe just don’t. Who does that these days, anyway?

Gold is hard to value: it doesn’t generate cash flows and it has historically been seen as a way to protect purchasing power given its scarcity, ability to be stored and transactional characteristics (can be used as a medium of exchange, but rarely is anymore).

One could argue that the recent rise in gold closely correlates to the recent growth rate of M2, something that many have advocated that will eventually lead to inflation (this is a dated argument that still persists despite the fact that inflation has remained quite tame – something to do with velocity of money and the fact that QE stimulus doesn’t get in the hands of households and rather only helps increase commercial bank’s reserves). But the argument that QE doesn’t lead to inflation because it has no impact on velocity of money (as money stays stuck in bank reserves) might be losing its appeal now, and Russel Napier makes a solid argument for Central Banks becoming irrelevant:

“This broad money growth is created by governments intervening in the commercial banking system. Governments tell commercial banks to grant loans to companies, and they guarantee these loans to the banks. This is money creation in a way that is completely circumventing central banks. So I make two key calls: One, with broad money growth that high, we will get inflation. And more importantly, the control of money supply has moved from central bankers to politicians. Politicians have different goals and incentives than central bankers. They need inflation to get rid of high debt levels. They now have the mechanism to create it, so they will create it.”

This all means that forecasting inflation is harder than it looks, and whilst we do think that higher M2 doesn’t necessarily lead to inflation, we’re forced to acknowledge that the current level of monetary growth is the Marvel universe to what Batman and Superman used to be back in the days: M2 is growing at 23% year-on-year in the US (June 2019’s rate was 2.04%), and M3 in Europe is growing at 8-9% (already close to the peak of 11.5% reached in 2007, despite only being at the early innings of a recession… and I don’t even like baseball).

Source: Themarket.ch

But for those who have been following gold closely (can the real Grant Williams please stand up?), they know that the rally is not a 2020 thing: the bullish trend started two years ago, mainly driven by the recurrent fall of real rates. As highlighted in Grant Williams’ research earlier this month, when real rates of return for cash fall, then gold becomes one of investor’s favourite assets to protect purchasing power, hence the relationship.

There are fundamentals behind the gold rally, as well as technical drivers. We all kind of know the fundamentals behind it: the fear of inflation which could eventually lead to currency debasement, a fear that has been top of mind for investors given the size of the recent stimulus of central banks and governments on the back of the COVID crisis.

More recently, the lower move in the US Dollar has also given a boost to the gold rally as a dollar decline fuels inflation through higher US import prices (and prospects for high inflation favour demand for gold), as well as the loosening global financial conditions, which end up benefitting mainly emerging market countries (who own dollar-denominated debt and lower dollar means less interest payments), which again should support inflation.

Beyond these fundamental drivers, one should always bear in mind that Gold is a commodity that can actually be delivered, a dynamic that does not happen in equity and credit markets (to clarify with an unimpressive sarcastic joke, buying Apple shares won’t lead to iPhones delivery). With that, there are also technical reasons behind the recent gold rally, which funnily enough are somewhat intertwined with the reason why, during the lockdown, your Amazon orders ended up taking longer than usual. As Jon Nieuwenhuijs wrote back in April:

On March 14, 2020, President Trump started curbing passenger flights between Europe and the US. Including those from Switzerland, where the four largest gold refineries in the world are located. This didn’t happen in isolation. Passenger flights all over the world were being curbed. One of the most important airports in London—home of the largest gold spot market by trading volume—is Heathrow. Since March 10, 2020, arrivals at Heathrow started declining from 600 flights per day, to 250 two weeks later. On March 23, 2020, three refineries in Switzerland were temporarily shut down due to the coronavirus.

Normally, airlines transporting gold and refineries manufacturing small bars from big bars, or vice versa, keep the price of gold products across the globe in sync. If supply and demand for gold in one region is out of whack relative to another, arbitragers step in (buy low, sell high). But with planes not flying and refinery capacity crippled, everything changed.

This has led to the highest ever physical delivery notice to be issued, as differences between spot prices and future prices allowed arbitrageurs to lock in profits, leading them to buy spot and deliver the gold to, in this case, the New York area.

Source: Bloomberg

Looking ahead, the market is currently pricing negative rates starting in Q3 2021, meaning that real rates are already poised to be low or negative without even considering inflation. Intuitively, that makes sense as it is indeed hard to see the US Federal Reserve changing its stance to a hawkish one given the current macroeconomic backdrop. So, as the Fed Funds rate continues to trend lower, real rates (= nominal rates – inflation) will likely continue to trend even lower, a positive scenario for gold investors. And if we ever have any inflation, then even better. What might go against a gold rally in the short-term? Stronger US Dollar and better-than-expected economic prints.

Whilst we do not know where gold will end up six months or a year from now (we can only speculate), keep it in your radar. It’s a helpful indicator to assess where the market stands with regards to the soundness of the global financial system, something that is quite at risk at present times.

Source: New York Times

Flagging the US Dollar decline for those of you in a hurry

The US Dollar had its worst monthly sell-off since September 2010 in July, shedding 4.4% in July. Since then it has rebounded almost 1%, but what interests us is not really the magnitude of the movements, but rather their meaning (beyond the fact that, for Europeans, it’s now cheaper to buy Vuori shorts and Yeti coolers).

Source: Financial Times

There seems to be positive sentiment behind Gold and Silver, as well as Bitcoin, all of which signal that the market is starting to maybe consider potential alternatives to a US dollar centric system. Yes, we know, it’s way too early to tell, and there are many reasons why we might have had such weakness in the greenback: COVID cases in the US spiking whilst the rest of the world seems to be managing a careful reopening (See the most recent Axios on HBO interview if you want to see for yourself why this has happened), trade tension with China arising again, or the prospect that the second round of fiscal stimulus will disappoint the market (a trillion ain’t enough…).

Given the importance of the US Dollar for the overall markets, we’re studying closely both the bear and bull cases for the asset and will follow up with a deep-dive in the next month on both sides of the conversation.

Two interesting charts on equity markets

Executives are selling their equity stakes, and whilst this isn’t necessarily a huge red flag, it’s something to bear in mind when looking at the overall equity market sentiment. As reported by Bloomberg earlier this month:

“Corporate insiders, whose buying correctly signalled the bottom in March, are now mostly sellers. Almost 1,000 corporate executives and officers have unloaded shares of their own companies this month, outpacing insider buyers by a ratio of 5-to-1, data compiled by the Washington Service showed.”

Secondly, Companies are piling up on cash, and rightfully so. Roger has written extensively about the deflationary risks of hoarding cash, i.e. piling up cash reserves (both as an individual and as a company) in order to have a safety net to face future uncertainty. Individuals have started doing that (see recent spike in the savings rate) and we now have complementary data that proves that companies are tagging along, through the cutting of structural costs and the raising of as much cash as possible through new equity issuance and follow-on offerings.

Source: Wall Street Journal

The cash reserves conversation is incredibly important, and companies are behaving in a way that is aligned with what Roger has mentioned in the past. The current financial industry favors larger companies who have the ability to get access to liquidity, either through government funding, financial institutions or institutional investors. This will only worsen the opportunity set for small and medium enterprises (who employ 70% of US workforce) as they do not get the same funding opportunities, leading up to a further increase in the Herfindahl Index, and a decrease in competition. Whilst this might be good for equity market performance (strong cash balances are usually good for investment fundamentals), it is destructive for the broader economy.

You can now go back to your warm buckets of Bud Lights, Coronas, Super Bocks, or whatever brand you support at home. We love them all (but are becoming more partial to juicy Hazy IPAs hailing from the central coast of CA…yes, Tim edited this article and his pretentiousness has no limits).