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With the equity and fixed income markets plunging in recent weeks, investors would be running for the hills if they knew where to hide. To say there’s a lot of uncertainty out there would be an understatement of the highest degree.
There has never been a time in the history of investing where interest rates were so low or where the Fed’s balance sheet had gotten so large. Never mind trying to deal with both. Unwinding all of that to combat inflation without blinking in the face of a potential recession is going to be an unbelievably challenging job.
With interest rates climbing 25 basis points in March and then another 50 bp on May 4, it’s obvious that we are now well into a new monetary tightening cycle. The Fed also finally stopped buying assets (QE) during March, but that was only after growing its balance sheet to a record of over $8 trillion (35% of GDP). Similarly, M-2 Money Supply in the US had grown to a record of over $19 trillion (84% of GDP)! Now, the Fed faces an extraordinarily difficult task of managing a “soft landing” by carefully raising rates and downsizing its balance sheet without causing a crash.
It’s always possible that the Fed will shift gears and become extremely tough on inflation, but that’s unlikely to happen. Even if they get moderately tough, there’s likely to be a certain amount of fallout in fixed income and equity markets. More probable is that the Fed will blink and continue along its path of tightening but not to the point of driving the US economy into recession. If that’s the case, then many of the things that have worked so far in this early stage of the tightening cycle will continue working.
Many economists predict a potential recession in 2023, but that might be an overreaction. Historically, the Fed has always seemed more concerned about economic growth and maintaining a stable economy than inflation despite its dual mandate to manage both. Currently, markets anticipate over eight interest rate hikes, with overnight rates climbing from 0.3% to over 2.8%, between now and the end of 2022. The 10-Year US Treasury yield has already risen from under 1.2% last summer to over 3.0% today. But even if we get to a point where overnight rates climb to 3.0% or higher, that would still represent an accommodative monetary policy stance since the long-term average Fed Funds rate is 4.95%. For now, interest rates remain exceedingly low.
In this environment, investors are finding it extremely challenging to find a place to put their money to work. Going into cash is no solution either since inflation steadily eats away at its purchasing power. At the same time, “riskless” government bonds and bank accounts pay less than the current rate of inflation.
Commodities may provide a safe haven, but before jumping in, 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 outperforming, but investors are unlikely to find them by just buying ETFs that track commodity indices.
During times like these, doing fundamental analysis can really pay off. Investors who are willing to do the homework, or work with investment managers who will 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 investors in commodities is to buy things blindly without spending enough time researching and analyzing. For instance, lots of people attempt a shortcut by purchasing 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 that they blow up spectacularly during times of stress. Other ETFs get wound down during heightened market volatility, defeating the very reason they were purchased by unwitting speculators.
With commodities, it is especially important for the investor to understand what he is buying. Commodities can be extremely volatile because the underlying futures markets can move up and down by large percentages on any given day. A great example of that is how at the start of COVID, oil futures briefly traded below zero but then snapped back shortly thereafter.
When commodities get extremely volatile, companies in those markets can quickly become distressed. But leverage is almost always a contributing factor as well. Commodity companies that fail usually have far too much debt to weather a normal economic cycle; alternatively, they sometimes fail due to unexpected swings in their book of commodity hedging derivatives.
It depends on which market you’re studying, but the intelligent investor will be well advised to spend sufficient time researching each market to determine whether there’s a fundamental change occurring.
Within precious metals, gold and silver markets look very interesting and can serve as an inflation hedge against inflation risk of fiat currencies where there’s less and less discipline about money printing. Cryptocurrencies can serve the same inflation hedging purpose, but they offer 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 supply and demand fundamentals behind it. For example, ESG concerns are more and more relevant for certain commodity markets these days, and they too may impact long-term future demand for those commodities.
As a final point, commodity producing companies with the lowest cost of production will usually come out on top, provided that they also have a clean balance sheet that can weather lots of storms.
As we noted earlier, the most important thing is conducting diligent fundamental analysis. Before investing in a commodity producing company, it is crucial to ascertain that it has a good management team, that their incentives are aligned with shareholder incentives, that they have low-cost operations, and that they are big enough to have a satisfactory spread of fixed costs across the operation. The next few quarters will be challenging for investors, but a return to the basics may provide some relief.