All the King’s Men – November 10, 2023

Wealth Management • Nov 11 2023
All the King’s Men – November 10, 2023
Morgan Lewis Posted on November 11, 2023

All the King’s Men

This week was nothing short of a bloodbath for the hard asset trade, and, to some degree, a continuation of the sheer bliss that began last week in financial assets. While hard assets got smoked, the S&P 500, the Dow, and the Nasdaq all finished the week higher. The positive week for the indexes was, however, something of a pyrrhic victory. Major index gains came on extremely narrow breadth and from only a handful of the “magnificent” mega-caps. In a sickly sign to be sure, the small cap Russell 2000 index not only failed to keep up with the big boys, it was crushed by 3.08%.

HAI, however, doesn’t expect this recent episode of hard asset underperformance to last. HAI continues to believe that all signs point toward a secular shift in investment dynamics dramatically favoring years of hard asset outperformance over financial asset counterparts. Timing the turn, as ever, continues to deliver fits. Nevertheless, conviction remains that the secular turn higher in hard assets looms on the other side of volatility. Expectations are firm that hard assets represent the generational opportunity in markets today.

In the short-term, price and fundamentals don’t always jibe, and this week provided a case in point. Despite negative price action, the week actually offered more evidence to bolster conviction in the new era of hard asset market leadership.

In Friday’s release of the latest University of Michigan Surveys of Consumers report, consumer sentiment suffered another big drop for the fourth straight month. This time, sentiment fell by a hefty and very notable 5.3%. Consumer sentiment has been as low as it now is only three times, and all three were recessionary eras. The further reacceleration of deteriorating sentiment from already recessionary levels is not a good sign for anybody or anything.

That, however, wasn’t the most concerning finding to emerge from this latest UMich update. That distinction belongs to the newly problematic trend developing in inflation expectations. As survey director Joanne Hsu put it, “Year-ahead inflation expectations inched up to 4.4%, indicating that the large increase between September’s 3.2% reading and October’s 4.2% reading was no fluke. The current reading is the highest since November 2022, and remains well above the 2.3–3.0% range seen in the two years prior to the pandemic. Long-run inflation expectations also rose, from 3.0% last month to 3.2% this month, the highest reading since 2011.”

High inflation expectations are self-fulfilling. An inflation psychology influences behavior and translates into inflationary actions. Consumers expecting higher future prices pull forward consumption to buy now at what they expect are today’s lower prices. It is a behavior that drives demand, and, by extension, self-fulfills higher prices and entrenches inflation dynamics. Similarly, businesses expecting higher inflation also expect to incur higher costs. In response to such expectations, they raise selling prices.

Again, inflation expectations are critical. Once inflation psychology is established, it can spawn an inflation spiral. The UMich data is alarming for two specific reasons. The first is obviously inflation itself. As mentioned, inflation expectations breaking higher fuel a much greater risk for higher entrenched rates of inflation down the road. Secondly, recall the central theme of recent HAIs—that the ultimate bubble of our time is a “confidence bubble.” That confidence is in the ability of government policy to always manufacture the perpetual goldilocks conditions necessary to keep financial assets bubbling higher in perpetuity. The UMich data suggests that when it comes to the Fed’s ability to deliver target rates of inflation, confidence is suddenly breaking down fast. And make no mistake, in a confidence bubble such as ours, like a cheap sweater, pull one thread and the whole thing can unravel. This week, inflation expectations were a strike-one against the confidence bubble.

Also this week, one of the foremost commercial real estate research firms, Green Street, offered important insights on commercial real estate (CRE) pricing trends. Green Street’s Commercial Property Price Index (CPPI) is the benchmark CRE source for investors. Importantly, in the latest October update, the CPPI accelerated its decline from what had been a slow grind lower to an uncharacteristically sharp 3.3% plunge. The CPPI usually changes in very small increments. When big changes manifest in the index, they typically indicate that a substantial and accelerated directional trend is being established. This is bad news for the economy, and it’s very bad news for banks.

Banks are already under the gun. They have largely languished without recovery from the recent banking fiasco. In fact, usage of the Fed’s emergency funding facility, established for the banks as a temporary rescue facility during the acute phase of crisis last Spring, soared higher by $3.9 billion this week (its largest jump since June) to reach a fresh new record high above $113 billion. Banks are biding their time at best. Now, as the largest holders of CRE loans, they have a whole new source of acute risk on their hands. If CRE prices begin an accelerated drop as the CPPI projects, it likely won’t be long before bank stress reemerges as a headline issue.

What’s even more troubling is that the sudden downdraft in CRE prices came prior to Monday’s WeWork bankruptcy announcement that will undoubtedly put further intense pressure on CRE prices and send a cascading ripple effect into urban center CRE specifically.

Eerily, October’s outsized 3.3% drop in Green Street’s CPPI bears striking similarity to an identical 3.3% drop suffered in September of 2007. That was an unusually large drop in the CPPI that acted as something of a canary in the coalmine, warning of the great recession that started just three months later. Again, banks are highly vulnerable. If the government’s intervention of newly created emergency programs and billions of dollars fails to ultimately “stabilize” the banking sector, it’ll pull on a second thread of the tenuous confidence-bubble sweater. If the banking crisis re-intensifies, it’s a big strike-two against the confidence bubble.

Late on Friday, after markets closed, a potential strike-three emerged. After both Fitch and S&P had previously stripped the U.S. of their highest investment-grade credit ratings, Moody’s Investors Service has now threatened that it’s also inclined to downgrade the nation’s credit rating. In the latest heavy hit to the omnipotent government theory and the “everything is fine” confidence bubble, the rating assessor lowered its U.S. credit outlook to negative from stable on Friday. In its statement, Moody’s said that amid higher interest rates, without measures to reduce spending or boost revenue, fiscal deficits will likely “remain very large, significantly weakening debt affordability.”

William Foster, a senior credit officer at Moody’s, said, “Interest rates have shifted materially and structurally higher… This is the new environment for rates. Our expectation is that these higher rates and deficits…mean that debt affordability will continue to pressure the US.”

Moody’s negative projections reflect what it sees as the likelihood of higher-for-longer interest rates amid an environment in which, just this week, interest expense on federal debt has now breached $1 trillion for the first time ever, and federal deficits are now running at $2 trillion and rising.

In HAI’s view, Ed Al-Hussainy, a global rates strategist at Columbia Threadneedle Investments, summed up the situation best. As he said, what matters “is less the aggregate rating and more the constant reminder to markets that fiscal risk is rising.” Absolutely right. Strike three for the week against the confidence bubble.

Given the current set-up, HAI isn’t interested in throwing caution to the wind for a FOMO-driven panic bid into the “magnificent” few.

To the contrary, HAI remains enamored by the building case in support of the hard asset thesis. Again, any sustainable continuation of the last decade’s financial asset bubble-bull market rests entirely on market confidence that policy makers can and will deliver a new round of perpetual goldilocks conditions.

The environment, however, has dramatically and emphatically changed on a large-scale secular basis. As recent HAIs have detailed, monetary policy and now Treasury market functioning are both increasingly compromised by sky-high debt and deficits that threaten a terminal debt doom-loop. 

This week we are reminded of three further strikes to the sustainability of the confidence bubble. Inflation is still running well above target, and now we are informed that inflation expectations are breaking loose and heading higher, signaling a confidence breakdown. The always crucial banking sector is barely hanging on for dear life as it suffers collateral risk from both higher interest rates and now a newly accelerating drop in CRE prices. At the same time, U.S. credit faces further downgrade as the bond market demands higher interest rates as compensation for absorbing massive debt issuance, even as those higher rates dramatically accelerate insolvency risk and the debt doom-loop dynamics. Worse yet, the ratings agencies are now making plenty of noise that debt, deficits, and interest rates have crossed the Rubicon, and that a new era has begun. It is as Ed Al-Hussainy suggested, what matters most in the context of a confidence bubble is “the constant reminder to markets” that we’re not in Kansas anymore, and that the old era of policy orthodoxy is over.

HAI continues to believe we are indeed entering a new era for financial markets, complete with new rules and a new category of market leadership in hard assets. At present, however, most market participants are still playing by the old rules of the old game. HAI doesn’t know when that old “game” will clearly, obviously, and undeniably end, but suspects, despite ongoing market jubilance, that the sand is draining rather rapidly out of the hourglass.

Whenever the old market regime transitions fully to the new, HAI strongly expects hard assets to emerge as the top performing regime-change assets—for good reason.

Over the last year, HAI has made numerous references to “peak cheap oil,” “peak cheap gold,” and “peak cheap copper” dynamics. To illustrate the bullish outlook for hard assets, let’s review the “peak cheap commodities” dynamics and contrast them with the fundamental underpinnings of the U.S. debt problem Stanley Druckenmiller refers to as the “200-foot tsunami just 10-miles out.”

In the oil patch, U.S. shale has been responsible for 90% of global oil production growth over the last decade, but recently shale production growth has been rolling over. Shale has very high production decline rates. It needs aggressive reinvestment and higher oil prices to keep production growth on par with growing demand. In recent years, we’ve seen cap-ex seriously constrained. And while oil prices have had spikes to higher levels, shale requires consistently higher prices to grow production economically. We don’t have a peak-oil problem, but a peak-cheap-oil problem. We have more demand than supply can handle on a forward basis, and we need higher prices to incentivize the added supply.

When it comes to gold, recall the S&P Global finding that “there were roughly 180 major gold discoveries (over one million ounces in reserves) in the 1990s, 120 in the 2000s, 40 in the 2010s, and none since 2019.” The large, cheap, and easy to extract gold deposits have already been picked. Again, like with oil, it’s not a peak-gold problem, but a peak-cheap-gold problem. At current prices, we have a developing asset scarcity problem. As former NY Federal Reserve Bank analyst and renowned Credit Suisse strategist Zoltan Pozsar said, “gold is coming back on the margin as a reserve asset.” That’s a game changer for gold demand that’s only in its infancy. We’re only now beginning to see that demand manifest. So far this year, China, the world’s second largest economy, has spearheaded record levels of global central bank gold purchases through the first nine months of the year. Year over year, global central bank buying has already surpassed last year’s all-time record by 14%, and demand is now running at a pace the World Gold Council just called “voracious.” With growing asset scarcity and a resulting tightening in future supply, we will need much higher gold prices to unearth supply sufficient to meet what is likely to be an extended period of surging gold demand.

As for the vital red electrification metal, copper, consider the recent Financial Times article titled, “Copper Producers Warn of Lack of Mines to Meet Demand for Metal.” According to the FT, the world’s largest copper producers have warned that there’s a lack of mines under development to deliver enough of the metal to keep pace with demand stemming from the clean energy transition. The bottom line is that while S&P Global forecasts a doubling of copper demand by 2035, adequate supply is nowhere to be found. The result is what S&P describes as a “chronic gap” now building between supply and demand. Again, this is not a peak-copper catastrophe, but a peak-cheap-copper problem that necessitates time, investment, and higher copper prices to address.

In short, the point is that commodity producers now face a secular struggle to deliver enough supply to meet booming demand. That’s an incredibly bullish fundamental tailwind.

Meanwhile, by contrast, U.S. policymakers are “producing” far too much debt to be absorbed by not nearly enough demand. That’s an incredibly bearish headwind that’s an inescapable fundamental problem for government policy makers. Government policy alchemy must find a way to resolve that problem without triggering a full debt crisis or causing skyrocketing interest rates in order to maintain the confidence bubble and allow for continued smooth sailing higher in financial asset prices. Betting that policy makers can pull-off such alchemy is certainly a bet one can make. It’s just not, at this late stage of an unsustainable situation, a bet HAI would make.

Rather, HAI much prefers the risk/reward opportunity present in the bullish fundamental tailwinds secularly supporting choice hard assets.

As this week’s market action exemplifies (through the harsh punishment doled out to oil, gold, copper, and other commodities across the board), short-term market moves can be incredibly tricky, fickle, and sometimes brutal. That said, hard asset exposure, at current prices, where demand is above supply on a secular basis while simultaneously being underweight financial assets whose price performance depends on the perpetual effective functioning of old-era monetary and fiscal policy activism, is likely to be the most rewarding investment strategy, not necessarily for a given day, week, or month, but on a secular timeline encompassing the next several years.

The current market pricing regime depends upon confidence that central planners can and will maintain perfect goldilocks conditions in perpetuity. That means a return to a set of conditions very unlikely to occur anytime in even the remote vicinity of soon. Furthermore, current market pricing also requires no recession, and no further geopolitical escalations that could outright put the match to that already bursting powder keg.

In HAI’s view, given the massive and escalating challenges, a future of a perpetual policy-manufactured goldilocks isn’t at all likely to unfold. What’s holding current market pricing intact, rather, is unquestioned confidence on the part of market participants that policy makers, like Oz the great and powerful, can successfully pull off any miracle. But, when old policy breaks down and new activist policy prescriptions fail, as we are starting to see, the curtain gets pulled back to reveal the magician as mortal. At that point, confidence in the omnipotent Oz evaporates.

In considering the consequences of such a development, recall economist Peter Bernholz’s recent warning that, “when a confidence bubble finally breaks, it tends to break abruptly.”

When the market reaches a recognition point that unwavering confidence in the current government policy trajectory is grossly misplaced, the confidence bubble (the ultimate bubble) risks irreparable breakage—“abruptly.” Just as Louis Carroll said of Humpty Dumpty after his “big fall,” so it is with burst bubbles—“All the king’s horses and all the king’s men couldn’t put Humpty together again.”

Now is not the time to build portfolios on what may soon prove foundations of sand. This is a time to invest upon foundations of rock. That means allocating capital toward assets already deep into trough valuations, where the price is simultaneously well supported by natural economic forces and extremely bullish fundamental supply/demand outlooks. In today’s environment, no asset class better fits that description than hard assets.

Weekly performance: The S&P 500 was up 1.31%. Gold was off by 3.08%. Silver was down 4.30%, platinum was slammed, down 10.45%, and palladium was crushed by 13.25%. The HUI gold miners index was hit by 7.79%. The IFRA iShares US Infrastructure ETF lost 2.39%. Energy commodities were very volatile and hammered on the week. WTI crude oil was down 4.15%, while natural gas tanked by 13.71%. The CRB Commodity Index was off 2.98%, and copper was down 2.45%. The Dow Jones US Specialty Real Estate Investment Trust Index surged 2.23%. The Vanguard Utilities ETF was down 2.79%. The dollar index was up 0.82% to close the week at 105.72. The yield on the 10-yr U.S. Treasury was up 4 bps to end the week at 4.61%.

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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