Crescat Capital's Portfolio Manager Tavi Costa and Chief Investment Officer Kevin Smith presented arguments that the U.S. is experiencing stagflation and that Federal Reserve cannot do anything to improve the economy.
Costa showed a chart comparing the Atlanta Fed's forecast of gross domestic product (GDP) to U.S. 10-year break evens, or the expectation of where the consumer price index will be a decade from now. It shows a divergence, with the former decreasing and the latter increasing. This indicates stagflation, similar to, but worse than, that seen during the 1970s, Costa said.
"We believe the Fed is trapped and there's nothing it can do because the many past years of using monetary policy to rescue the economy created ultralow interest rate environment, inflation we have and the bubbles in the stock market and fixed income markets." - Kevin Smith
Smith picked up the stagflation thread and illustrated the significant drop in real GDP that happened between Q2/21 and Q3/21. It decreased from 6.75% last quarter to 1.3% this quarter, as forecasted by the Atlanta Fed.
"This really is the kind of stagflationary environment that we think we're in and that could evolve pretty quickly," he said.
These metrics, showing stagnant growth but increasing inflation, again illustrate the Federal Reserve's current sticky situation.
"We believe the Fed is trapped and there's nothing it can do because the many past years of using monetary policy to rescue the economy created ultralow interest rate environment, inflation we have and the bubbles in the stock market and fixed income markets," Smith said. "[The bubbles are] on the verge of busting, due to inflation or rising interest rates to fight inflation, no matter what the Fed does."
Smith cited a recent piece by Bill Dudley, former CEO of the New York Federal Reserve, in which he opined the U.S. Fed is at the risk of what he described as "the last war." Dudley expressed concern that once inflation gets out of control, the Fed will have to increase interest rate too quickly, thereby propelling the economy into a recession.
Also with respect to the Fed, Costa pointed out, recent and future changes among its members (current chair Jerome Powell's term expires in February 2022), could "trigger a real disorder on the monetary side."
Smith reiterated that the equity market is generally overvalued. Growth of the Russell 1000 Index, measured by relative price to book, is 60% higher than it was during the tech bubble. At the same time, though, the breadth of the NASDAQ Composite Market is faltering, the FAANG stocks have started weakening and more earnings growth slowdown is expected for the Big Five: Facebook, Apple, Amazon, Microsoft and Google.
Given existing and increasing inflation, investors have started rotating out of growth stocks and into segments of the market offering protection along with value. For Crescat Capital, stocks offering true value and appreciation potential are commodity related and in the natural resource sector. They include oil and gas, energy-related industries, basic materials, fertilizer companies, forest product companies and precious metals.
As for precious metals, a comparison of the VanEck Junior Gold Miners Exchange-Traded Fund (GDXJ) versus the VanEck Gold Miners Exchange-Traded Fund (GDX) shows the junior gold miners broke out from a multi-month-long resistance, Smith noted.
Silver has not yet done so, but based on its history, it will, Costa purported. Both metals are expected to behave as they have historically during inflationary periods, thus, move to the upside.
Crescat Capital believes it is positioned to capitalize on an upward trend in gold and silver prices, given that the precious metals explorers in its portfolio cumulatively have 136 rigs actively drilling over the next 12 months.
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