What Next?

With bond and equity indices down sharply for the year to date and crypto-currencies in free fall, portfolio stabilizers have taken on more importance. Yes, gold is down from its most recent highs, but it’s still slightly ahead of its year-end levels. And yes, as I’ve pointed out many times during the past few months, cash may appear to be a foolish choice when viewed against the current inflationary backdrop, but that notion quickly evaporates when markets start to crack.

The bottom line is this: our gold and cash positions, which together make up roughly 45% of our holdings, continue to shelter our portfolio from volatility.

Even so, the outlook for the next few months (and perhaps years) appears dismal. The political and socio-economic backdrop remains extremely challenging—consider just a few of the trials ahead:

-Monetary authorities finally recognize that they’ve followed an unsustainable course, but have no idea how to reverse policy without triggering a serious recession;

-If governments compensate for a tighter monetary policy by ramping up their spending even more, they undermine central bank policy— if they don’t, they add to the economic pain;

-World stock markets are now in bear market territory. Retail investors are net sellers and most corporations are lowering earnings guidance.

-All these developments negatively affect consumer behaviour. The question for the next twelve months: how will people cope with sharply higher food and utility bills, climbing credit card debt, sky-rocketing car loan costs and fuel prices, and higher mortgage payments—all while inflation-adjusted wages are declining? Perhaps the stock prices of Amazon and Walmart (see charts) tell the story better than any economist could.

-All along, there are additional unknowns related to the ongoing Covid saga and, potentially far more disrupting, the West’s new proxy war in Ukraine. In terms of the latter, the unintended consequences of sanctions of which I warned in my Strategic Update of April 4, are now apparent to all. Most of the sanctions have proved unworkable or inflict serious pain on Europe’s economy. Despite grandiose EU rhetoric to the opposite, most European nations now buy oil and natural gas on Russia’s terms, settling their bills in Rubles, or acquire it from intermediaries who go along with Moscow’s rules. Meanwhile, the effect of various sanctions on consumer inflation in numerous developed and less developed economies is indisputable. And further escalation or prolongation of the conflict (which is clearly what America and NATO wants) will only intensify these pressures.

“The recent surge in heavy weapons shipments to Ukraine amount to NATO going to war with Russia through a proxy and arming that proxy.”

Russia’s Foreign Minister Sergey Lavrov

“America stands with Ukraine. We stand with Ukraine until victory is won.”

U.S. House of Representatives Speaker Nancy Pelosi

First, A Recession

In short, a recession may be closer and more painful than expected. Ordinarily, positioning an investment portfolio for a weakening economy is fairly simple: you aggressively curb exposure and remain defensive. This time it’s different. Ever since the 2008 Great Recession, the world’s central banks have been recklessly accommodative, keeping rates low and persistently supporting an expanding economy and sharply rising financial markets. One obvious result is the highest rate of inflation in half a century.

Few people are conversant with the realities of an inflationary backdrop—not just from an investor viewpoint, but also with the social implications. After all, ever since 1980 we’ve been living in a predominantly deflationary world, made possible at first by Fed Chairman Volcker’s aggressive monetary tightening, then further accelerated by globalization and the evolution of technology.

Some economists feel that the forces of deflation are so entrenched that they could quickly reassert themselves. My personal view is that it would take an enormously harsh and prolonged central bank stance, all in the face of growing social unrest, to make that happen. Still, it’s an outcome that can’t be ruled out.

Going forward, the keys to igniting a deflationary comeback or allowing a further sharp rise in inflation are firmly in the hands of the central banks. Below are two starkly different scenarios, one outlining the consequences of a further determined tightening of monetary policy, the other showing what happens if the central bankers lose their nerve. Of course, as I said earlier, the course followed by monetary and fiscal authorities may at any time be influenced by events related to the pandemic or, to an even larger extent, the Ukraine War and other geopolitical developments.

Do either of these scenarios mandate a major rethink of our portfolio approach? Let’s look at the individual asset classes and see how they’d hold up in each circumstance, starting with the equity sector.

The stock market is likely to stay under pressure, at least while the Fed and other central banks talk tough. Remember that the recent 0.5% U.S. interest rate hike (the biggest in two decades), leaves the Fed Funds Rate still below 1%. Adjust that for inflation and you end up with a Real Fed Funds Rate that is still deeply in minus territory, at an alarming -7.3%. As an aside, real rates in the Eurozone average – 8%, in the UK at -6%, and in Canada at -5.7%. Given this situation, I would be very surprised if central banks caved any time soon. On the contrary, I expect at least three more rate increases, with negative consequences for global stock markets. To be sure, there will be bounce-backs from key support levels, but in the current environment we would not “buy the dips”.

So why hold equities at all? First, just as there are companies you want to avoid in the most inspiring bull market, there are sectors or individual stocks that will hold their own or even prosper in a bear trend. Some of our top picks in the pipeline, utilities and agricultural industries have been largely unaffected by the 18% drop in the S&P500 so far this year. Others, especially in the energy and fertilizer sectors, have actually rallied. Yet some of our commodity holdings, such as base and precious metals miners, have posted drops, mainly motivated by fears of rising fuel and transportation costs.

Going forward, even in an restrictive central bank backdrop, we continue to see commodity prices escalating, with positive consequences for the now modestly valued quality producers. Looking beyond the commodity sector, we continue to favour companies capable of generating strong cash flow and, ideally, offering attractive and sustainable dividend income.

No stock portfolio is without its disappointments. Our biggest setbacks have been in the consumer, financial and technology segments, even among top quality names.

What about bonds? In past issues we have repeatedly warned against fixed income holdings, a stance that has largely proved correct. Given the more negative economic sentiment of recent days, we feel the time is right to nibble at bond ETFs targeting 3-5 year maturities. We note that several of these yield around 3.5%, which is worth looking at. After a wait of more than two years, we’re reallocating 5% of our model portfolio to high-quality bonds and 5% to Treasury Inflation-Protected Securities (TIPS).

Some analysts are disappointed with gold; we are not. In the summer of 2020, the yellow metal reached an all-time high of $2,050/oz., before retreating to the $1,700 level. Gold tested the previous high in a few weeks ago, as the invasion of Ukraine unfolded, but then sold off again—despite a military showdown involving nuclear powers and soaring inflation rates. That, understandably, is not what investors expected.

However, to judge the metal’s performance, we have to understand the broader context. Yes, inflation and a major geo-political crisis were part of the picture, but there are other realities. One key factor is that the Fed’s promise of several rate increases and the reality of a war in Europe pushed the U.S. dollar to unexpected highs. Expressed differently: in Euros, Japanese Yen or even Swiss Francs gold actually posted new all-time highs this year.

When will gold advance to new highs in dollar terms? Given geopolitical tensions, a likely retrenchment in the dollar’s value, robust central bank buying and a positive supply/demand profile, another stab at the $2050 resistance level could materialize any time. What may delay a rally for a few months is the prevailing central bank narrative. As long as the inflation fight dominates the rhetoric, gold may stay contained; once economic concerns take center stage again, we’ll be headed higher.

We strongly feel that a gold position of 10% to 15% of your investment portfolio is worth maintaining during these extremely uncertain times.

Our small experiment with Crypto-currencies has been educational. In my Strategic Update of a year ago (May 2021, “An Update on Gold, A Primer on Cryptos”), I explored whether the likes of Bitcoin, Ethereum or companies providing infrastructural capacity to the digital economy deserved to be included in our model portfolio. My stated conclusion then: “I see little harm in buying a 2% position in cryptos after the recent, massive pullback—let’s say 1% in Bitcoin and 1% in Ethereum, which I consider to be the two most intriguing choices. With banks and mutual funds entering the space, it’s not inconceivable that they will stage a robust rebound.”

Well, it’s been an interesting ride since (see chart left). Bitcoin more than doubled, reaching close to $70,000, then entered a period of sporadic sell- offs that led to its recent low of around $26,000. Ethereum behaved similarly; other crypto proxies fared even worse. Such volatility in itself is not new to me; I’ve seen that hundreds of times with junior stocks in areas like mining, energy or biotechnology. What I’ve never seen before is that huge fluctuations occurred in the context of massive market capitalizations, In Bitcoin’s case, the current market cap is $569 billion; with Ethereum it’s $242 billion. In that context, the comprehensive crypto-crash of the past few weeks can only be attributed to the wholesale panic sell-out of an entire generation of followers, or massive dumping by those who joined the game early and accumulated millions or billions of digital currency.

Is it worth holding our tiny position as proxies of a new asset class? I think the answer is yes—not because I’m confident of an imminent rebound in crypto-currencies, but because it’s imperative to keep an eye on the inevitable digitization of money. There is little doubt that central banks will soon introduce their own digital currencies, in an attempt to both advance transaction surveillance and create an alternative to platforms like Bitcoin. But can a government-offered digital alternative to fiat currency inspire the people? I doubt it, which is why variations of the crypto theme will likely continue on.

Chances are that we’ll learn a lot more as different players expose themselves. Will the big players reposition themselves and will they manage to draw in small investors once again? Will the much touted institutional adoption of cryptos actually happen or will the financial industry start to distance itself from the concept? Will governments target and even ban crypto alternatives as they digitize their legal tender? Or will they allow Bitcoin and others to coexist with their own currency? A lot of questions need to be answered before the crypto space can rival gold as a protection against currency debasement.

Even so, we’ll stay the course for now, knowing that our 2% total exposure may be halved again or, alternatively, may double or triple in value.

Best wishes,

Peter Cavelti