With interest rates rising and inflation rising, investors are finding this extremely difficult to do … [+]
With stock and bond markets plummeting in recent weeks, investors would be running for hell if they knew where to hide. To say there is a lot of uncertainty out there would be a gross understatement.
There has never been a time in the history of investing when interest rates have been this low or the Fed’s balance sheet has been this large. It doesn’t matter to deal with both. Unraveling all of that to fight inflation without blinking at a possible recession will be an incredibly challenging task.
With interest rates up 25 basis points in March and another 50 basis points on May 4th, it is evident that we are now in a new monetary tightening cycle. The Fed also finally stopped buying assets (QE) in March, but that was only after it expanded its balance sheet to a record over $8 trillion (35% of GDP). Similarly, the US M-2 money supply had grown to a record over $19 trillion (84% of GDP)! Now the Fed faces the extraordinarily difficult task of creating a “soft landing” by carefully raising rates and shrinking its balance sheet without causing a crash.
It’s always possible that the Fed will slow down and hit inflation extremely hard, but that’s unlikely. Even if they do moderately harden, there will likely be some impact on bond and equity markets. More likely, the Fed will blink and continue on its tightening path, but not to the point of pushing the US economy into recession. If this is the case, many of the things that have worked so far at this early stage of the tightening cycle will continue to work.
Many economists are forecasting a possible recession in 2023, but that could be an overreaction. In the past, the Fed always seemed more concerned with economic growth and maintaining a healthy economy than with inflation, despite its dual mandate to manage both. Markets are currently anticipating more than eight rate hikes, with overnight rates rising from 0.3% to over 2.8% by the end of 2022. The US 10-year Treasury yield has already risen to over 3.0% from under 1.2% last summer. today. But even if we get to a point where overnight rates rise to 3.0% or higher, that would still be an accommodative monetary policy stance given that the long-term average fed fund rate is 4.95%. For the time being, interest rates will remain extraordinarily low.
In this environment, it is extremely difficult for investors to find a place to invest their money. Getting into cash is not a solution either, as inflation is steadily eating away at purchasing power. At the same time, “risk-free” government bonds and bank accounts pay less than the current rate of inflation.
Commodities can offer a safe haven, but before jumping into it, investors need to understand that not all commodities are created equal. Companies that have commodities exposure on the long side with clean balance sheets and reasonable cost structures should continue to outperform, but investors are unlikely to find them simply by buying ETFs that track commodity indices.
In times like these, fundamental analysis can really pay off. Investors who are willing to do the homework, or who work with investment managers to do it for them, can avoid paying unreasonable prices for companies with business plans that no longer make sense given the current economic outlook.
The riskiest thing for commodities investors is buying things blindly without spending enough time on research and analysis. For example, many people try to take a shortcut by buying ETFs without really knowing what’s behind them, or even reading their offering documents. Some ETFs use derivatives or lots of leverage, which can increase the risk of them exploding spectacularly in times of stress. Other ETFs unwind when market volatility increases, defeating the very reason they were bought by unwitting speculators.
When it comes to commodities, it is particularly important for investors to understand what they are buying. Commodities can be extremely volatile as the underlying futures markets can move up and down by large percentages on any given day. A great example of this is how oil futures briefly traded below zero at the start of COVID, but then collapsed again shortly thereafter.
When commodities become extremely volatile, companies in these markets can quickly find themselves in trouble. But leverage also almost always plays a role. Resource companies that fail typically have far too much debt to survive a normal business cycle; Alternatively, they sometimes fail due to unexpected fluctuations in their inventory of commodity hedging derivatives.
It depends on which market you’re studying, but the intelligent investor would do well to spend enough time studying each market to see if a fundamental change is taking place.
Within the precious metals markets, the gold and silver markets are looking very interesting and can serve as an inflation hedge against the inflationary risk of fiat currencies where there is less and less discipline in printing money. Cryptocurrencies can serve the same inflation hedging purpose, but they come with their own unique risks such as volatility, unproven regulatory and tax regimes, and even fraud.
The list goes on and on. Investors can study each commodity market and the underlying supply and demand fundamentals. For example, ESG concerns are becoming more relevant to certain commodity markets today, and they too may impact long-term future demand for those commodities.
After all, commodity producing companies with the lowest production costs will usually come out on top provided they also have a clean balance sheet that can weather many storms.
As previously mentioned, the most important thing is to do thorough fundamental analysis. Before investing in a commodity producing company, it is important to ensure that it has a good management team, that its incentives are aligned with shareholder incentives, that it operates cost-effectively, and that it is large enough to have a satisfactory spread of fixed costs across the board entire operation. The next few quarters will be challenging for investors, but a return to basics could bring some relief.