Barron's Streetwise - Tasty Treasuries and Crashing Gold

Episode Date: September 23, 2022

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With record levels of dry powder available for investment, find out what's in store for private markets in 2025 and beyond. Listen to Crafting Capital in partnership with UBS at partners.wsj.com slash UBS, Spotify and Apple Podcasts. If you just look at this relationship between real rates and gold, it would suggest that the price of gold could fall to $700 an ounce or even lower. Hello and welcome to the Barron Streetwise podcast.

I'm Jack Howe, and the voice you just heard is Michael Darda. He's the chief economist and market strategist at investment bank MKM Partners. And when he says gold could fall to 700 an ounce or lower he's predicting something pretty dramatic because gold sells now for well over twice that much michael also says it's time to buy long-term treasury bonds in a moment we'll hear why we'll also talk with another strategist about attractive u.S. stocks and a money manager about good deals overseas. And we'll get caught up on the Fed, inflation, house prices. It's a financial buffet, but with the pacing of a hot dog eating contest.

Listening in is our audio producer, Jackson. At least I think he's listening in is our audio producer jackson at least i think he's listening in jackson you there yet i'm here let's start with the fed i know you love a little fed chat jackson uh go ahead and put on your uh ask me about the dot plot ball cap and your i have passionate feelings about the neutral rate shirt. Well, that's that one's in the wash, but I've got the hat. Good enough. We're going to talk about what the Fed did this past week, what it's likely to do next. We'll explain a little monetary nerd speak and we'll touch on what all of it means for stocks and houses. Now, the Fed this past week did exactly what it was expected to do. It raised short-term interest rates by three-quarters of a point.

The new target for the so-called Fed funds rate is a range of 3% to 3.25%. You'd think that move would have already been priced into stocks and bonds, but both fell. That move would have already been priced into stocks and bonds, but both fell, perhaps because Fed Chair Jerome Powell was perceived as talking tough at a news conference after the hike. The Fed remembers raising rates to try to bring down the fastest inflation in four decades. Powell said, I wish there were a painless way to do that. There isn't. In other words, raising interest rates could hurt the economy, but that's just a price we'll have to pay to get control of inflation. And it wasn't just words. The Fed puts out a quarterly document called the Summary of Economic Projections that explains some of its thinking.

That document showed modest downgrades to what the Fed expects for economic growth and unemployment. But if you're reading the summary of economic projections, you might just be skipping to the dots. That's table two in the latest edition titled Federal Open Market Committee Participants Assessment of Appropriate Monetary Policy, but it's popularly known as the dot plot because there's a dot for each participant and each time period. And together, the dots show where those people who are closest to setting rates think that rates are headed. The Fed is careful to say that the dots are not plans and shouldn't be viewed as predictions, and investors more or less ignore that advice.

And this past week, the dots shifted higher. Back in June, they showed the Fed funds rate ending next year at 3 7⁄8%. Now they say 4 5⁄8%. That's a three-quarter point shift. Goldman Sachs takes the new dot plot to mean that investors should expect another three

quarters point hike in November, then a half point in December and a quarter point in January. We'll see. Note that the dot plot goes all the way out to 2025, and it actually shows the Fed funds rate falling in 2024 and 2025 by a total of one and three quarters points. The implication is that the Fed will get control of inflation by the end of next year and then begin bringing rates back down. Goldman says don't count on it. Goldman figures that basically if inflation somehow comes down without the economy going into recession,

the Fed could leave rates where they are until something important breaks. Now, this kind of forecasting matters to an investor who's thinking about buying bonds. There's a portfolio of long term Treasury bonds called the iShares 20 plus year Treasury bond ETF. But many investors just call it by its ticker symbol TLT. Treasuries have a reputation as a safe investment, but TLT has lost 29% so far this year. That's about five points worse than the US stock market. That's because rates have been rising and that tends to push

bond prices lower and long term safe bonds are particularly sensitive to changes in interest rates. Michael Darda, the chief economist and market strategist at MKM Partners, says it's time to buy TLT because he thinks yields are close to peaking. He says that the market is already pricing in big rate increases from here, even though inflation expectations are already coming down. That is one heck of a rise over a fairly short period of time in nominal rates. But if you look at the policy rate relative to like expected inflation in the bond market, that kind of a rise would even be more significant because inflation expectations have come down this year. And we're getting evidence, at least in some of the more forward-looking indicators, that the economy probably won't be able to sustain that level of rates for any period

of time. So you've got a yield curve inversion that's intensifying a pretty vicious downturn in residential real estate. By yield curve inversion, Michael means that yields on short-term treasuries, two-year ones, for example, are higher than yields on long-term treasuries. That's taken as a sign that the economy could weaken. And when Michael mentions a real estate downturn, he means, for example, that home sales have fallen for seven straight months and that the 30-year mortgage rate has shot up to well over 6%. And while house prices are still up from a year ago, they've started falling sequentially

from one month to the next. Our view is you have fairly elevated risks now of a 2023 recession. And with recession and disinflation, ultimately, that'll cause the Fed to reverse course. They don't want to talk about that now. They're pushing against this idea of cutting rates anytime soon. They still intend to raise them. But if they raise them in a way that overshoots and causes a business cycle downturn, then, you know, eventually they'll have to be some kind of a reversal. U.S. inflation is over 8 percent, but Michael says he expects it to fall toward 2 percent fairly rapidly over the next year to year and a half. Some of these slower moving stickier measures are going to take longer to

moderate, but they will moderate. So wages, rental inflation, services inflation, a lot of that stuff is tied to leases and contracts. And so it takes time when economic conditions change for those prices to reflect changing conditions. But the forward-looking indicators are telling us now that inflation will be coming down. That would be good for treasury prices, so Michael recommends buying TLT. It might seem odd to favor, say, a 20-year treasury bond recently yielding 3.9% at a time when inflation is over 8%,

especially when a two-year treasury pays slightly more, about 4.1%. But it's less odd if you think that inflation is about to collapse to 2%. Then you might be happy to lock in that 3.9% for a long time. Now, Michael recommends TLT as part of a combination or pairs trade. Buy TLT and short gold, he says. We've talked about gold before in this podcast, but not for a while. And that itself says something. Gold is sometimes called an inflation hedge, but inflation is now raging and the price of gold is down slightly this year.

Michael says gold is not a good hedge against inflation. It's what he calls an inverse hedge for real interest rates. In other words, take interest rates, subtract the rate of inflation. The result is called real interest rates. When those go higher, Michael says, gold goes lower and vice versa. This idea that gold is an inflation hedge or predicting inflation in some way really doesn't hold up to close scrutiny at all. But gold is an inverse proxy for real interest rates is much more compelling, even though it's not a perfect relationship.

Back in 1999, 2000, real rates in the treasury market were up around 375, 4%, really high real rates. In the late 90s, we had booming growth and that tail end of the investment internet boom and very high real interest rates. And gold was 250 an ounce. In 2011, we had real rates at minus one and a half, minus 2%, very low. And gold prices were pressing towards $2,000 an ounce. Expected inflation through that period averaged about 2%, sometimes higher, sometimes lower, with some volatility. So that huge move from $2.50 to $2,000 didn't have any correspondence to actual or expected inflation, but went hand in glove with a huge collapse in real interest rates. So gold moves opposite of real interest rates. And so far this year, real interest rates are up a lot.

Just take a look at Treasury inflation protectedation Protected Securities, which adjust for inflation. At the beginning of the year, five-year ones were yielding about negative 1.6%. Now they yield positive 1.5%. Michael says that either the gold price has to come down or real rates have to. And that's why he recommends buying TLT and shorting or betting against gold. If real rates come down, the investor would do well on the bonds. And if real rates stay high or push higher, the bonds might tread water. They might even lose a bit of money. But Michael says the bet against gold in that case could pay off

handsomely. As you heard earlier, he thinks the price could fall by more than half. Shorting, I'll just note, is for experienced investors and comes with plenty of risk. So most investors should interpret Michael's advice as him saying it's a good time to buy bonds and to stay away from gold. I spoke with another strategist this past week who also thinks now's a good time to buy bonds and to stay away from gold. I spoke with another strategist this past week who also thinks now is a good time for a contrarian move into bonds. We do think for the first time since 2019 that there is value in longer dated bonds. That's Julian Emanuel. He leads the equities, derivatives and quantitative strategy team at investment bank Evercore ISI.

During the context of a two year period where literally every asset allocator and I would dare say every member of the investing public has been completely convinced that bonds are a one-way ticket to capital loss so that the 60-40 portfolio over the last two years has probably morphed into the 65-35 or the 70-30. All of a sudden, to us, when you think about the fundamental rationale that bonds could actually fall in yield and prices rise with the potential that asset allocators and real money might move in, we are convinced increasingly that that kind of dynamic will be enough to offset the $95 billion a month in QT that the Fed is doing to keep, in a manner of speaking, longer-term yields cropped higher. When Julian says 60-40 became 70-30, he means that investors are starting putting more money into stocks and less in bonds. And when he says bonds could now do well enough to offset QT,

he's referring to quantitative tightening, which is another way of saying bond sales by the Federal Reserve. Julian recommends an option strategy of buying TLT calls and selling TLT puts. But here again, options aren't for everyone. Most investors can simply interpret that as, if I've been underweight in bonds because yields were so low, they're higher now and it might be time to add some bonds. And that's quite enough for now about bonds and rates and gold. Jackson, did you get enough Fed chat or are you busy now filling out your Q4 fantasy Fed

brackets? I think I'm going to start Esther L. George, president of the Federal Reserve Bank of Kansas City. You're reading that right off the website. She joined in 1982. He says conversationally. MBA from the University of Missouri, Kansas City. I want to hear more about that.

But what I really want to know about is the stock market. Julian and a money manager I spoke with have ideas on what to buy there. That's next after this quick break. Calling all sellers. Salesforce is hiring account executives to join us on the cutting edge of technology. Here, innovation isn't a buzzword. It's a way of life. Welcome back. I recently wrote that financial markets are careening toward normal. What I meant by that is that even though some changes have been shocking compared with recent history,

they're not that unusual compared with the long term. recent history, they're not that unusual compared with the long term. That Fed funds target range, as I said, is up from just over zero at the start of this year to just over 3% now. And the dots say it could top 4.5% by the end of next year. That's precisely where the Fed funds rate has been on average in monthly data going back to 1954. The average is 4.6%. The 30-year mortgage rate has more than doubled in a year to 6.3%. But we have data on that going back to 1971. And the average there is 7.8%. You don't hear a lot of people now saying to lock in a mortgage while rates are below average, but the reality is we've been here and much higher before. So how about the U.S. stock market?

We're close to normal based on projected earnings, but still more expensive than normal based on trailing earnings. By that, I mean the S&P 500 trades at 16 times projected earnings for the next four quarters. That's down from 21 times projected earnings at the beginning of this year, and it's close to the 20-year average of 15.7 times. Whichever measure you go with, stocks seem priced to produce decent long-term returns, but there's no telling whether the market will overshoot average valuations on its way lower in the near term. Julian Emanuel at Evercore has thoughts on that. What this comes down to from a valuation perspective, from a price decline perspective,

is, is this a non-recession bear market or is this a recession bear market? Because if it's a non-recession bear market, the average of which over the last 100 years was seven months and down 27.7%, you could basically say that the June low down 24.4 or 24.5, whatever the heck it was, is sort of check the boxes. And our problem is that the discourse of the last 24 hours has drastically increased the probability that this is going to be a recession bear market. And if it's a recession bear market, the average over the last hundred years is a shade over 13 months and down 41.5%.

And recession bear markets tend to have two things. Number one, year-on-year earnings declines that average 15% and valuation troughs that tend to go to about 13 times. When Julian refers to the discourse of the last 24 hours, he means the Fed comments, which in his view, make a recession and another leg down for stocks more likely, but not quite a sure thing. Julian recently lowered his price target for the S&P 500 to a level that suggests 6% upside by year's end. And he recommended that stock investors favor what he calls free cash flow favorites. There has only been one bull market in 2022. And that's the bull market in cash. And that is a bull market that

is not likely to subside anytime soon. The Fed just told you that. And these companies are convex to that bull market. And not only are they convex to that bull market, but they have decided that they are going to excel in returning that cash to the shareholders via either share buybacks or dividends. Julian says that these free cash flow favorites, that's tough to say. Say it, Jackson. Free cash flow favorites. Three times fast. Free cash flow favorites. Free cash flow favorites, free cash flow favorites. Thought I would catch you on a favorites, but you delivered it cleanly. Congratulations.

Julian says that these free cash flow favorites also tend to have depressed valuations. And even though value stocks have recently done well after more than a decade of trailing growth stocks, Julian thinks that value stocks will outperform for longer. He recently ran a screen for the types of companies he's talking about. Companies with high free cash flow yields that return a lot of money to shareholders in dividends and stock buybacks. included Bank of America, home builder Lenar, oil refiner Valero Energy, Comcast, the cable company, and meta platforms formerly called Facebook. For a non-U.S. perspective, I checked in with Graham Forster, who's in charge of the international equity strategy at Orbis, which is South Africa's largest private money manager, overseeing about $30 billion.

Like Julian at Evercore, Graham likes value stocks. They're real economy businesses. They're energy, they're materials, and they're industrials. So you've seen very little capital investment through this cycle in those types of businesses. And I said it's naturally mean reverting, because if you have not enough capital investment, you see shortages. If you see shortages, you see prices start to rise, and that's what we're seeing today. Those shortages and rising prices have become inflation, and that inflation is causing interest rates to rise, and those rising rates are just the thing to bring valuations for these old economy businesses higher.

And we saw that in the early 70s, and we saw that in the early 2000s. We're seeing that now. And that's a process and it takes time. Graham says that he's finding good deals now in the industrials, materials, energy and financial sectors. He also says that the U.S. has outperformed overseas markets and looks expensive only because it has so many pricey growth stocks. If you compare similar old economy companies between markets, U.S. stock valuations look ordinary. You can look at an Alcoa, which is listed in the U.S. It's a big aluminum business.

And you look at a Norsk Hydro, which is listed in Europe. It's the same business. They're valued exactly the same, right? There's no inefficiency there. Alcoa is obviously short for Aluminum Company of America. Norsk Hydro sounds like it has something to do with water. In fact, it makes aluminum. But it used to make fertilizer using electricity from water.

Jackson, my fertilizer music, please. Now, we did an episode of this podcast just a couple of weeks ago on the World War I era Haber process developed in Germany for making nitrogen fertilizer from air and natural gas, no manure required. And I told myself I wouldn't discuss fertilizer of any kind, organic or manufactured, for at least a month. But let me make one very quick exception. Norsk Hydro got into fertilizer before World War I using a method from Norwegian scientists called the Birkland-Eide process, and it uses lots of electricity.

So the company built power plants near waterfalls. Thus you get Norsk Hydro. Ultimately, the Haber process proved more efficient. Norsk Hydro got into aluminum during World War II and oil and gas during the 60s. Then it divested both fertilizer and oil and gas in the 2000s, which explains why Norway's biggest aluminum company is named like a water company, and that's Nomanor. Now, where was I? Graham from Orbis and the stocks he likes. The stocks we've been really interested in have been the likes of Shell and Glencore.

So Shell is an integrated gas business, really. It touches roughly 16%, 17% of global gas. It doesn't produce that gas. It's got a big trading business. So it's touching the gases and it's matching buyers and sellers globally. And it's a pretty inefficient commodity in the sense it has to be liquefied and transported all over the world. That inefficiency and the fact that the world is fundamentally running short of the energy it needs and will for some time, that bodes well for Shell. And something similar is true for Glencore. It produces metals, including copper, nickel, cobalt, and zinc,

and it's seeing rising demand from batteries, including for storing electricity produced by solar panels and windmills and for electric cars. Glencore trading in those raw materials and producing those raw materials and producing a 25% to 30% free cash flow yield and paying it out to shareholders looks egregiously cheap to us, given the bright future it likely has in this type of environment. Thank you, Graham and Julian and Michael, and thank all of you for listening.

Jackson Cantrell is our producer. DraftKings, if you're listening, he's got a fantasy Fed idea, and you're welcome in advance. The dot plot parlay. I like it. I'll take the over and the under and the in-between, just to be sure. Subscribe to the podcast, rate it, review it on Apple. Unless you don't like it, then you can really let me have it on MySpace.

See you next week.