A Historic Capital Rotation Is On Tap

Summary

• Global economic growth has underwhelmed versus expectations generally since 2011.
• Lower than expected growth versus expectations has caused investors to chase growth at almost any price, and duration in their bond investments almost at any price.
• This crowded investment landscape is about to experience a wholesale change, with global growth outperforming expectations led by China and the United States.
• This idea was discussed in more depth with members of my private investing community, The Contrarian. Get started today »

"If everybody indexed, the only word you could use is chaos, catastrophe… The markets would fail." - John Bogle, May 2017

"A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years… We are profoundly worried that this could be a risky allocation over the next 10." - Sanford C. Bernstein & Company Analysts (January 2017)

"Life and investing are long ballgames." - Julian Robertson

Introduction

In November of 2015, I opined with a November 23rd published article that, "U.S. Stocks Have Become A Deflationary Asset". The thesis of the article was that U.S. stocks had risen alongside bond prices the past five years, and commodity stocks and emerging market stocks had suffered, as U.S. stocks and bonds became the safe haven for global capital flows in an investment landscape where global growth had fallen short of expectations.

Little did I know that after a brief capital rotation in 2016, global economic growth would again continue to fall short of expectations for much of the next five years, punctuated by a global COVID-19 pandemic, and the capital flows towards the disinflation/deflationary winners, including the disruptive technology leaders like Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), Alphabet (GOOGL), (GOOG), MercadoLibre (MELI), Microsoft (MSFT), NVIDIA (NVDA), Shopify (SHOP) and Tesla (TSLA) would reach a crescendo peak higher than I ever imagined possible.

These capital flows, aided and abetted by the current structure of the market, which is formatted in a way that investment assets are increasingly being funneled into price insensitive and valuation insensitive passive investment strategies, have taken relative and absolute valuations to places that seemed incomprehensible five, ten, or fifteen years ago.

(Source: Nomura)

Yet, here we stand, looking at an environment where a majority of global sovereign bonds are offering negative real yields, and stocks are trading at record high valuations.

(Source: Advisor Perspectives)

In summary, global capital flows have been funneled into stocks and bonds anticipating the current status quo to perpetuate in the future, specifically, an environment where economic growth continues to disappoint versus historical precedent. Looking forward, in this investment framework, lower for longer becomes a self reinforcing cycle, as the debt overhang, and corresponding interest expense outlays become ever more burdensome.

Sounds grim, does it not?

However, what if the black swan is not a nefarious deflationary event or a continuous disinflationary decline at the behest of disruptive technology, and instead is a revival in global growth led by China, and the United States, which catches a majority of investors in the wrong disinflationary/deflationary position?

This alternative reality, is actually closer than we think, in my opinion, and global capital flows have amplified the importance of the capital cycle, which is about to come full circle in an inflationary environment that very few investors are currently prepared for right now.

China Is The Root Of Global Economic Growth And There Are Green Shoots Right Now

Ever since 2011, the root source of global growth disappointing versus expectations has been China, as the world had simply positioned at the start of the decade (circa 2011) for China to grow at a faster pace than it has been growing for much of the past decade.

These expectations were borne out of the incredible growth that China delivered from 2000-2010, where the country experienced a cumulative growth rate that changed more lives faster than any global economic expansion in history.

This growth drove the global commodities market, and commodity prices experienced a boom from 2000-2010, that was followed by a bust, when global growth after 2011 disappointed.

(Source: Longview Economics, Macrobond)

Financial markets tend to go to extremes, and the "bust" part of the boom/bust commodities cycle has been unprecedented, as the chart above illustrates, yet this relative extreme is creating historic absolute opportunities

Building on this narrative, economic growth in China has been exceeding expectations in the second half of 2020, with a vigorous bounce back recovery from their own COVID-19 shutdown.

Headlines have turned positive, and investors are starting to take notice as this snapshot from Invesco's recent take on China illustrates.

(Source: CNBC)

The economic recovery in China is broad based, with retails sales posting their first year-over-year gains recently, record restaurant and travel bookings, and the manufacturing sector bouncing back firmly into expansionary territory.

(Source: CNBC, Markit, Caixin)

Evidence of this rebound is starting to flow through to the commodities market, with bellwether copper prices recently making new highs in 2020 as the following charts shows.

(Source: Author, StockCharts.com)

Copper prices are not the only commodity mover as the $CRB Raw Materials Commodity Index has rebounded sharply.

(Source: Bloomberg)

The irony should not be lost here in that China, which was the root source of global economic strength from 2000-2010 and the root source of global economic weakness from 2011-2020, appears to be once again leading the global economic recovery after being the birthplace of COVID-19. Adding to the irony, the same recovery is happening in the U.S. too.

U.S. Economic Growth Is Surging Too

For many months, I have watched the Citigroup Economic Surprise Index exceed expectations.

(Source: Yardeni, Citigroup)

Strength in the U.S. has been led by the housing market and a robust continuing recovery in retail sales, with new home sales making new decade highs and existing homes sales following suit, fueled in part by pent up demand, low inventory, and record low interest rates.

(Source: Author, StockCharts.com)

Looking at the chart above, the magnitude of the recent surge lower in interest rates has seemingly validated the long-term hypothesis of Lacy Hunt and Van Hoisington, who have famously espoused that we are in a debt trap, with ever growing layers of debt unable to spur sustained economic growth above trend that overcomes this hurdle.

Hunt and Hoisington dismiss short-term bursts of growth, like the one we are seeing now in the third quarter of 2020 where GDP growth is now estimated to be above 35% on a quarterly basis, which is shown below by the Federal Reserve Bank of Atlanta's GDPNow model, as transitory.

(Source: Federal Reserve Bank of Atlanta)

Thinking out loud, those espousing deflationary and disinflationary forces as all encompassing, forget that the United States enjoys the twin advantages of enjoying the world's sovereign currency, where the debts of the U.S. are generally denominated in U.S. currency, and the ability to effectively create money out of this air, via the stroke of a key as Ben Bernanke famously articulated.

That reality is actually happening as money supply growth has surged, to a degree that stands out over decades.

(Source: Jeroen Blokland)

This surge in money supply, and rebounding economic growth, has thus far not caused a surge in U.S. interest rates, which would normally already be at least 100 basis points higher by a range of historical comparisons.

(Source: Yardeni, Citigroup)

What is causing interest rates to stay persistently down, even with both commodity and equity prices rebounding?

Personally, I have thought it was fear, which would abate with time; however, there is another element in play, which is intervention.

Treasury Market Is Dominated By Intervention Via Fed Purchases

If you have ever read the history of the Federal Reserve, chronicled in books like, "The Creature From Jekyll Island", you can understand where the doubts about the omnipotence of the Federal Reserve emanate from, even if confidence in the Federal Reserve is at all-time highs today.

Ironically, this confidence in the Federal Reserve has grown, as the Fed has become more involved in the Treasury market, as the sheer volume of Fed bond purchases has become enormous, directly impacting and distorting the bond market.

Looking for evidence of how large Fed bond purchases have kept prices unnaturally elevated, I came across this piece by John Authers that highlighted this model from Mike Howell of Crossborder Capital Limited.

(Source: Mike Howell, Crossborder Capital Ltd., John Authers)

The following quote from Authers' article describes the model shown above, and the deviation in 10-Year Treasury's.

Mike Howell of Crossborder Capital Ltd. in London built a model to predict 10-year Treasury yields based on four factors that usually correlate closely with them: the amount of U.S. liquidity, U.S. ISM data, the ratio of copper to gold, and the change in the Australian dollar. The predicted course of yields using those factors is shown by the red line, while the actual performance is in yellow.

Similar to the Citigroup Economic Surprise Index shown earlier, 10-Year Treasury Yields have not moved higher, suppressed by outsized Federal Reserve purchases.

This suppression in bond yields, however, is accelerating economic growth, monetary velocity through additional borrowing, which is most evidenced in the housing market, and creating additional commodity demand, as commodity supplies remain under pressure from a starvation of capital that followed the historic commodity bear market. Said another way, the seeds that will fuel the end of the nearly four decade bull market in bonds have already been planted, and further yield suppression only accelerates the growth of inflationary pressures.

The Endgame - Sustained Inflation Is On The Horizon Sparking A Historic Capital Rotation

Lakshman Achuthan, the co-founder of the Economic Cycles Research Institute, was recently on CNBC, and he hypothesized that future inflationary pressures are in the middle of a sustained rebound.

(Source: Lakshman Achuthan, CNBC)

I will go further, and say that the capital cycle is going to increase inflationary pressures, as falling supply intersects with stable or rising demand for a host of commodities.

(Source: GMO)

This is going to fuel inflation, and rising interest rates, particularly at the longer end of the yield curve, in an environment where the Federal Reserve has already stated that they are tolerant of higher inflation for a sustained period of time, to balance out the time inflation traded below their 2% threshold.

In a new policy framework, agreed to by all 17 top Fed officials, the central bank said it would allow inflation to run above 2% for some period of time. This is known as an “average inflation target.”

“The Committee seeks to achieve inflation that averages 2% over time and therefore judges that, following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time,” the new policy framework said.

Source: MarketWatch, Federal Reserve

In practicality, the yield curve is going to steepen as inflationary pressures build, Fed bond purchases decline as a percentage of issuance, which has already happened to a degree as bond buying has tapered from its earlier peak in 2020, and this is going to fuel a historic capital rotation out of growth stocks, the largest of which are the markets longest duration assets, and into value equities.

For this reason, I am actively short the iShares 20+ Year Treasury Bond ETF (TLT) via put options, expecting significantly higher interest rates at the longer-end of the yield curve.

(Source: Author, StockCharts.com)

The chart above is unadjusted for dividends, and I think as interest rates normalize, the sharp rise over the past two years can be reversed in symmetric fashion, once some of the current fear and uncertainties dissipate, leaving the recovering economic reality profiled earlier in this article front and center for investors and traders.

Unfortunately, sharply rising long-term interest rates and a steepening yield curve will not be positive for all assets. Specifically, large-cap growth stocks, which dominate the composition of the S&P 500 (SP500) today, are effectively the longest duration assets in the financial market, and rising long-term interest rates will be one catalyst for selling pressure rising in these names.

Building on this narrative, the prospect of rising long-term interest rates combined with historically high starting valuations, has value investors who prognosticate on asset class returns historically pessimistic.

(Source: GMO)

For perspective, these forecasted real asset class returns are projected to be worse than they were in January of 2000 or January of 2008.

Alternatively, commodities and commodity equities remain historically cheap on both an absolute and relative basis.

(Source: Author, StockCharts.com)

In summary, I am old enough, experienced enough now, and with enough scars, that I remember when stocks like Realty Income (O) sold for double-digit yields in late 1999 and early 2000, and very few investors wanted these equities when I thought they were undervalued. At that time I was a registered broker working at Charles Schwab (SCHW) still advocating value investments, and as part of my early role in Schwab's advice initiative with Chicago Equity Analytics, I was head over heels for out-of-favor value stocks, including REITs. For the record, this occurred in an environment where an investor could buy a 10-Year Treasury and secure a 6% yield. Adding to the narrative, a similar valuation case could be made for undervalued REITs following the 2008/2009 collapse, which I took advantage of personally with my direct purchase of General Growth Properties and First Industrial Real Estate (FR). Conversely, after a two-decade run of outperformance, REITs are not the heart of the value opportunity today, even though I think there are targeted REITs and financials that are undervalued.

Rather, the heart of the value opportunity is in commodity stocks, and the most undervalued subsector of this commodity sector, from my vantage point, which is natural gas equities, has already had its inflection point, with many of these out-of-favor natural gas stocks significantly outperforming the SPDR S&P 500 ETF (SPY) by a wide margin on a year-to-date basis in 2020. If we are anywhere close to right in our analysis, which collectively we have put an unbelievable amount of time and energy into the past five years, we are only at the very beginning of this outperformance and forthcoming historical capital rotation, and it is going to be imperative for investors to think differently about their portfolio construction and asset allocation strategies. Said another way, what has worked previously in an environment of disinflation/deflation will not work the same way going forward in an environment of rising inflationary pressures.

Disclosure: I am/we are short SPY AND TLT VIA PUT OPTIONS IN A LONG/SHORT PORTFOLIO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.