02 Nov Baggot General Update Q3 2020
It was a very mixed quarter overall for global markets. Returns were generally lacklustre across developed equity markets. US & Japanese equity markets had decent returns but for investors without a currency hedge, much of those returns evaporated via Euro strength vs both the Dollar & the Yen. The developed market which represents the greatest Value, the UK, continues to under-perform due to the Brexit malaise. European equities were very sideways in Q3, but there have been pockets of strength, particularly among small & mid cap sectors but also in more specific growth focused areas.
Emerging Markets have been a mixed bag. Latin America has been a dog where currency weakness has not helped European investors, but also it is the most levered global region to commodities. They have remained weak overall this year outside of precious and industrial metals. Latin America is a Value play and Value is still out of favour. I expect Value as a factor and Commodities in general to be the best performing areas of the next five years.
Emerging Markets in Asia have acted much better in Q3 as a result of stimulus and also the fact that Asian countries have generally responded to the threat of covid-19 in ways that have impacted their economies less.
The Dollar was generally weaker in Q3. Being the reserve currency of the world, Dollar weakness has had a reflationary effect on the rest of the world.
Long dated developed market bonds used to give you risk-free returns, now they represent return free risk. Emerging market bonds are providing relatively attractive yields in inflation adjusted terms, however risk profiles in the space have generally moved up to a 5 from what used to be some 3’s and mostly 4’s. For a risk profile of 5, Equities have generally provided better returns and in many cases, they generate just as much income.
Other than in the shorter term, cash continues to be an uncomfortable place to hide when you are now paying 0.65% to sit on deposit in a pension structure.
We’ve just exited what is typically the most seasonally weak period of the year for Equities (May – October) and now entering the period of the year where momentum tends to beget momentum. Those with tax-losses tend to book them this side of the calendar year creating a negative imbalance between buyers and sellers which drives those assets lower. Conversely those with capital gains tend to wait until the next calendar year to take profits creating a positive imbalance between buyers and sellers which drives those assets higher. The effect becomes increasingly magnified the closer you get to year end. Given many of the Value names and assets are down on the year (particularly Oil related names), we do not think this bodes well for performance between here and year end, but it could create exceptional opportunities coming out of year end in that space. For those areas in the portfolio that have done well this year (Precious Metals & Miners in that space come to mind), I’d expect this effect to be a major supportive tailwind as we get closer to year end.
Obviously this has been an abnormal year for all of us and there are times when seasonality does not work out the way you would expect it to (November 2009 through April 2010 comes to mind as an example where it did not work to plan) but over very long periods of time, it usually pays to be more cautious during the Summer and early autumn months and to expect better returns from November through Spring.
Here is the 30 year seasonal pattern for the German Dax;
Here is the 30 year seasonal pattern for the FTSE 100;
It is a very similar pattern regardless of which developed equity market we are looking at and the pattern holds over even longer time frames than the last 30 years. Of course it is important to look for correlation between the current market behaviour and the seasonal pattern and that is something we always incorporate into our process at Baggot, but I highlight seasonality because we are heading into what is typically a good time to own Equities. I tend to be more cautious during the summer months as a result of seasonality and I always have to remind myself that this is generally a time of year to be more optimistic about returns over the next 5 – 6 months.
The US Election
There is a lot of uncertainty heading into the US election. The polls tell us Biden will win in a landslide. Perhaps he will but polls were wrong about Trump winning over Hillary Clinton. They were also wrong about Boris Johnson winning. Furthermore the polls were wrong about the Brexit vote. We also know Biden represents higher taxes and a more diplomatic stance toward China, in terms of Trade. Two factors that the majority are not in favour of.
Regardless of who wins the election some outcomes will be similar.
• Democrat Congress + Trump President = More Fiscal stimulus monetized by the Fed & US banking system
• Republican Congress + Trump President = More Fiscal stimulus monetized by the Fed & US banking system
• Democrat Congress + Biden President = More Fiscal stimulus monetized by the Fed & US banking system
• Republican Congress + Biden President = More Fiscal stimulus monetized by the Fed & US banking system
I believe the beneficiaries of a Trump win would be dramatically different to those under a Biden win. A Biden win, would probably be bad for big US Technology firms (FAANG+M) and it would most certainly be good for Green energy and Oil prices. Biden speaks openly about shutting down fracking in the US. If this were to happen, this would obviously impact the level of supply that is available in the
global oil market, which would obviously be very supportive of Oil prices. The common denominator under both is that we are going to get more stimulus, probably directed at Infrastructure.
There is also potential for a contested result which could create a lot of volatility, not just for US markets but also for the rest of the world.
Covid-19 remains a factor but a diminishing one in my view for global markets. Let’s look at the data;
Daily change in reported worldwide covid cases going back to January 21, 2020;
Daily change in reported worldwide covid deaths going back to January 21, 2020;
Daily change in reported US covid cases going back to March 2, 2020;
Daily change in reported US covid deaths going back to March 2, 2020;
Daily change in reported covid cases in Ireland going back to March 14, 2020;
Daily change in reported covid deaths in Ireland going back to March 14, 2020;
As you can see cases are spiking but globally, in the US and in Ireland, deaths related to covid are not rising in tandem with the spike in cases as one would expect. I am not a medical expert, but in my opinion this is because Doctors are treating it much more effectively. What made it so lethal was the potential for a shortage of ventilators, but the risk of ending up on a ventilator has dropped dramatically as a result of blood thinners.
One thing that I think is very important to remember and something I have taught in my capacity as a lecturer over the years is that the media always hype negativity because we pay more attention to the media when there are things to worry about. Ever wonder why the evening news is almost always mostly negative? Because you pay more attention. When you pay more attention the ad revenue that supports the industry is higher. This is why they were still talking about the recession in 2010 when stock markets had already rallied 50% off
their 2009 lows. Markets are smart, they represent the total psychological make-up of all known participants. They discount what they know and look forward, not backward. Remember that! These graphs paint a much different picture to what the media and our scared politicians would have us believe.
Our view remains the same. We are a long term Dollar bear. There are many reasons for our view on the Dollar and we have spoken about it at length in previous updates, but ultimately it really boils down to two major factors;
1) Money supply growth has been much more aggressive in the US than has been the case for other developed world countries.
2) For quite some time US interest rates were significantly higher than in most other developed world countries. This drove money out of those countries and into the US as the Dollar was stronger and it paid a higher yield. That yield differential is no longer large enough to sufficiently compensate foreign holders for the currency risk that is inherent in holding Dollars.
The Dollar is the reserve currency of the world and much of the world’s debt is denominated in Dollars. When the Dollar goes lower vs other currencies whose nations hold a lot of Dollar denominated debt, the liability incurred by that debt declines. A weaker Dollar over the coming years should be a supportive tailwind for the rest of the world.
I’ve said it many times before but while Valuations are a very poor predictor of shorter term returns, they are by far the best predictor of returns in the longer term. When you look at the world from that perspective US equity indices are very likely to produce very poor returns over the coming years relative to Europe, Emerging Markets
and much of Developed Asia. Of course there are exceptions to the rule, there will be plenty of US companies that have a bright future, but most funds that carry US exposure do so at the index level, which in our view carries far more risk than we’ve seen in a very long time. When you add in the potential for Dollar weakness as well, we believe returns could be catastrophic for non-US investors in the coming years. As such, we have very little exposure to US indices across our investment products at Baggot. We favour European, Emerging Market and Japanese Equities.
We see a lot of risk in traditional 60/40 (Equity/Bond) portfolios because much of that 60% Equity exposure is invested in US Equity indices, while that 40% Bond exposure yields very little.
With interest rates pretty much at zero across the developed world and money supply growth exploding globally, we believe Gold is a better place to diversify risk than is the case in long-dated developed market bonds. Gold does not pay a yield but for holders, it has protected purchasing power for 6000 years. It is a finite resource valued in infinitely printable (zero yielding) currency.
We have a very bullish view of commodities as they are very cheap relative to Equities and even more so relative to Bonds.
The graph below is from the Goehring & Rozencwajg piece entitled, “We are entering into an era of inflation. Are you prepared?”
Most Agricultural commodities, Industrial & Precious Metals and even Energy have had such low prices for so long that producers have kept capex down for a long time. Commodities tend to run in these long boom and bust cycles. We believe the lack of capex has already sown the seeds of tightening supply in the future across most of the Commodity spectrum. Combine that with a declining Dollar, global population growth and the fact that commodity markets are very small relative to the size of financial markets – so it wouldn’t take a lot of money leaving financial markets and moving into commodities, to send prices dramatically higher….It is an asset class that we are excited about in the coming years and an area where we are actively seeking out opportunities for our clients.
I could go on about this for hours about commodities but one last thing I want to point out is that the trend toward Electric Vehicles (EVs) creates a lot of demand for industrial metals. Kevin Muir who is a very highly regarded trader and also writes The Macro Tourist (www.themacrotourist.com ) newsletter which I highly recommend wrote a piece recently called “Electric Picks & Shovels”. I want to share an excerpt from the piece with you;
Electric Picks & Shovels, by Kevin Muir
During the Great California gold rush, some of the best investment opportunities lay, not in the finding of gold, but in supplying the materials needed to prospect for gold. This brought about the term a “pick-and-shovel play” for the idea that investing in the items used in a boom is often a better risk/reward than participating in it.
You probably know this, but EVs take a lot of metal to produce. Here is a great summary from Aheadoftheherd.com about the different components:
Copper is utilized in an EV’s electric motor and wiring. An electric vehicle contains four times as much copper as a fossil-fuelled model. We also can’t forget residential chargers and public charging stations which require a lot of copper – consultancy Wood Mackenzie estimates that by 2030 there will be more than 20 million residential EV charging stations requiring 250% more copper. One of the largest manufacturers of public charging stations is targeting a 50-fold increase by 2025.
Lithium is obviously crucial in electrification due to its use in EV batteries. There is no substitute for lithium and it is expected to remain the foundation of all lithium-ion EV battery chemistries for the foreseeable future.
Nickel is popular with EV battery-makers because it provides the energy density that gives the battery its power and range. Increasing the amount of nickel in a battery cathode ups its
power/ range but, add too much of it and the battery becomes unstable, ie. vulnerable to overheating and a shortening of its lifespan.
Nickel is used in both of the dominant battery chemistries for EVs, the nickel-manganese-cobalt (NMC) battery used in the Chevy Bolt (also the Nissan Leaf and BMW i3) and the nickel-cobalt-aluminium (NCA) battery manufactured by Panasonic/Tesla.
Cobalt is a necessary ingredient in the battery cathode to provide stability and to maintain the battery’s cycle life – ie, how many times the battery can be discharged and recharged without loss of capacity.
What I liked best about this writer’s analysis is that they have taken a high and low estimate for EV production in 2030, and then examined how much extra of each metal would be required. Here is what they came up with:
Look at those numbers for the author’s reasonable estimates about EV penetration. They are quite high in relation to the metal’s supply. However, do you think the market is pricing the EV company stocks using those “reasonable” penetration rates? Not a bloody chance. There are sky-high projections baked into the prices of those companies.
The EV companies are using extremely optimistic forecasts, while the metal companies who supply the materials are priced as if demand will barely increase. It’s a mispricing that cannot continue forever.
The main bottleneck for EV companies has now firmly shifted from a “lack of capital” to concerns securing the needed materials for long-term production. Investors are throwing money at these companies telling them to ramp up production in the hopes of unseating Tesla and maybe becoming the new Amazon of this cycle.
However, what are the chances that this capital is being wisely invested in this “opportunity?”
I would much rather buy the things that are needed to fuel this increased production. This idea isn’t new, but two things have happened over the past couple of months that have shown the timing for this trade might be upon us:
• The EV bubble has blown so big, any fool with a nice autocad of a good looking vehicle has been given un-Godly sums of money to produce it (see above list of companies). The supply of many of these vehicles has been financed by aggressive speculators.
• More importantly, Tesla has shown the first signs of being concerned about securing raw materials for the production of their vehicles.
Back to my thoughts…..I think it is really important when considering how important commodities may be in the future to understand how much they matter in the new economy.
We are still very optimistic in our long term outlook for commodities, emerging markets and non-US Developed Markets (Particularly Japanese Equities) but we are still facing a lot of uncertainty particularly as we head into the US election. We stand ready to respond post-Election if we feel the need to do so.
We continue to see global fiscal and monetary stimulus as a major supportive tailwind in the coming year or so and feel very confident about the way we are positioned as we move forward into the last couple months of the year.
Chief Investment Strategist and Director