Weekly Hard Assets Insights
By David McAlvany

Boom Then Bust?

There’s rarely a dull week in our modern financial markets, and this one didn’t disappoint. A wide swath of high-impact concerns led to losses in September. Now, more than halfway through October, and without significant resolution of the issues facing markets and the economy, major indexes are back to all-time highs. On Friday, the Dow Jones closed the week at a fresh all-time high, while the S&P 500 made an intraday all-time high before pulling back to close beneath the previous record high. The Nasdaq Composite also rallied 7% off its recent lows, and sits just 1% away from its all-time high. While many industrial metals consolidated recent price surges and endured sharp pullbacks this week, other commodities such as oil, natural gas, gold, and silver were invited to the party and closed higher on the week.

In addition to ultra-loose financial conditions, ongoing global Central Bank liquidity in-flows, relentless momentum, and bubble dynamics, specific drivers of the ongoing stock price surge are the newly initiated earnings season and markets entering the strongest period of positive annual seasonality from now through the remainder of the year. Also of significant note, markets are likely front-running a hefty dose of pending corporate buybacks. A corporate buyback blackout period ends at the end of the month, and the buyback window opens on November 1st. Goldman Sachs estimates that companies will buy back a total of $160 billion worth of shares between November and the end of December.

Adding to the bullish tone on Wall Street, this week saw some notable improvement to market internals. The NYSE Advance/Decline Index, which tracks the number of companies moving higher versus those moving lower in price, finally made a new high for the first time since early last summer. The A/D index measures market breadth and indicates whether broad market price moves are being driven by many companies throughout the market or just a few. A rising A/D line indicates that this current rally has wide participation. Its breakout this week to new highs is a leading indicator suggestive of the likelihood for further market gains ahead.

While these factors argue for a continuation of the rally in the short to intermediate term, a laundry list of market risks remain. The threats of Fed tapering and eventual interest rate hikes, a serious non-transitory inflation problem, supply chain chaos, goods shortages, a brewing corporate profit margin problem, slowing growth concerns, and a possible China meltdown all loom overhead like a guillotine waiting to fall at any given moment’s macro eruption. As was said, markets are rarely dull, and our present moment is certainly no exception.

Concerns about the negative impact of non-transitory inflation, supply chain bottlenecks, and goods shortages were on the rise this week. Many voices, from Federal Reserve officials to corporate management teams, were weighing in on the emerging cost pressures and shortages.

Federal Reserve Chairman Jerome Powell is now begrudgingly backing away from his previously adamant “transitory” inflation stance. On Friday, Powell said, “The risks are clearly now to longer and more persistent bottlenecks and, thus, to higher inflation.” Powell went on the say that “supply constraints and elevated inflation are likely to last longer than previously expected and well into next year, and the same is true for pressure on wages.” That said, Powell affirmed that “I do think it’s time to taper; I don’t think it’s time to raise rates.” Atlanta Fed President Raphael Bostic made his opinion known, saying, “U.S. inflation is broadening, not transitory.” Meanwhile, Federal Reserve Governor Christopher Waller said on Tuesday that he is now “greatly concerned” that rising prices may continue and that inflation could be higher for longer than anticipated. Rather than inflation being transitory, it now seems the newly crafted position for Waller is that, “the escalation of inflation will be transitory….” Waller went on to say that if high inflation continues, “a more aggressive policy response” may be needed, but a rise in interest rates “is still some time off.”

While central bankers wrestle with the question of whether they have misdiagnosed inflation pressures as transitory, industry leaders are unambiguous in acknowledging price increases and in expecting them to continue. Shortages of workers, goods and materials, fuel, cargo ships, and semiconductors are causing companies around the world to struggle mightily to keep costs contained.

This week, consumer goods behemoth Unilever, a company that sells all forms of name brand products such as bath soap, tooth paste, condiments, laundry detergent, beverages, and ice cream, said, “We expect inflation to be higher next year than this year….” Unilever CFO Graeme Pitkethly said, “We continue to take pricing responsibly, and that’s in relation to the very high levels of inflation we’re seeing.” Pitkethly added that consumer goods industry inflation is in the “high teens.” Unilever pushed rising costs onto consumers by raising prices at the fastest pace in nearly a decade, and warned that prices could be increased even further next year as inflation increases and some of the company’s hedges against surging input costs expire.

Food and beverage company Nestle addressed the same topic on Wednesday. Echoing similar previous comments from 3M, Nestle said, “Inflation costs are rising faster than we can roll forward through pricing…. The situation has not improved. If anything, we are seeing further downsides compared to what we told you in the summer.”

The issues are not limited to household products and food and beverage companies. On Wednesday, electric vehicle maker Tesla, despite beating Q3 revenue estimates, warned that they anticipate upcoming factory and supply-chain headwinds to pressure margins going forward. Also this week, automaker Volvo Group warned that the global semiconductor shortage and supply-chain challenges will continue to put a lid on production. Another sector anticipating higher prices that will have broad impacts throughout the economy is airlines. This week, United Airlines warned to expect higher fares as jet fuel prices continue to rise.

Even communications technology and advertising firms were in the crosshairs. In addition to other problems facing the company, SNAP said supply chain issues and labor shortages caused brands to reduce advertising spending and diminished the “…appetite to generate additional customer demand through advertising.” The news hit share prices hard at other ad revenue companies such as Facebook and Twitter. Sean Sun, a portfolio manager at Thornburg Investment management, commented that if products are held up and not on shelves, “…advertisers aren’t going to advertise things they can’t sell.” So, the downstream effects of supply chain issues, labor shortages, and inflation run deep. Sun added that, “Investors are now thinking about risk/reward, and valuations in growth stocks leave less room for disappointment.” The portfolio manager’s comments on growth stock valuations causing less room for disappointment also apply to almost every other sector of the market. With the Dow and S&P back to all-time highs while sporting extremely stretched valuation multiples, companies across the board have incredibly thin margins for error.

One of the key elements of Bank of America global investment strategist Michael Hartnett’s growing concern over non-transitory high inflation is particularly important to highlight. Hartnett anticipates an inflationary wage growth surge in 2022, courtesy of the massive imbalance that has developed between labor supply and demand. His important observation is that, rather than Covid vaccines leading to a mass migration back into the workforce as was expected, vaccines mandates are having the opposite effect. Hartnett believes constantly rising stock market prices to be an added enabler of this weak labor force participation. As a result, Hartnett sees the bargaining power of labor dramatically increasing. He sees this dynamic echoed and affirmed by the exceptionally high labor quit rate that is uncharacteristically coinciding with very weak consumer confidence. If Hartnett is correct, then a highly inflationary wage-price spiral dynamic is primed to get cranking.

As mentioned in last week’s HAI, Mike Wilson, Chief US market strategist at Morgan Stanley, has already flagged the pending corporate margin squeeze and “serious risk to companies’ earnings prospects…” as a major issue that has yet to fully materialize. Wilson expects the issue to come to a head when “…the engraved invitations go out about earnings estimates for next year.” He sees the problem intensifying in Q4 reporting and throughout next year.

In line with Wilson’s view, this earnings season has been good so far. According to Bloomberg, of the S&P 500 companies that have reported to date, 84% have posted better than expected earnings. Bloomberg also notes that corporate results so far in this earnings season have postponed but not dissipated worries that cost pressures could slow the recovery. One observation supportive of concerns and of there being almost no corporate room for error is that firms surpassing profit forecasts have seen almost no share price benefit, while companies that have missed expectations have suffered dearly. In fact, Bloomberg points out that share price declines in the companies missing expectations have been the most extreme since they started tracking the data in 2017. In other words, while the looming anticipated corporate earnings and margin issues have yet to fully manifest, a reward-free risk dynamic is already taking shape and is likely to intensify in the next several corporate reporting periods.

According to Shane Oliver, head of investment strategy and chief economist at AMP Capital, earnings season optimism is being muted by the outlook for inflation, supply-chain bottlenecks, and Chinese growth concerns that are all “acting as a bit of a brake on markets.” Overall, to date, it is only “a bit of a break” as we continue to see markets broadly push higher. The observation that markets are continuing to rally to new all-time highs despite the fact that positive earnings results are not moving the needle for individual companies carries significant implications. It suggests that, rather than company specific events, the broad indexes, for now, are melting up more on overflowing liquidity inflow pressure and momentum encouraged by a now-ingrained market assumption that prices are backed by an unshakable and ongoing “Fed put.”

Therein lies part of the problem for policy makers with regard to the serious and increasingly apparent inflation problem. Reduce liquidity and raise interest rates to the levels necessary to quell inflation, and both markets and the economy look poised to take a potentially catastrophic beating. In that scenario, the economy, labor markets, and citizens will suffer significantly—at least until a fundamentally healthier economic landscape eventually emerges. Meanwhile, a lower stock market and a large and lengthy economic downturn will reduce government tax receipts dramatically through both reduced capital gains and income taxes. This would be a big problem for overly excessive government debt levels. With less tax income and higher interest expenses to be paid on the record government debt, a serious debt crisis becomes a significant possibility. 

That prospect poses very real reasons why the Fed may not actually go too far for too long towards truly tightening financial conditions, and may, in contrast, quietly opt to let inflation run hot with eventually even more liquidity and low interest rates as needed to inflate away excessive government debt burdens. The risk in that case is to the currency. This is what is being referred to in descriptions of a trapped Fed. On one hand, risk unleashing a miserably painful and persistent high inflation that ultimately risks ruining the currency. On the other hand, crush the economy and markets with tight financial conditions and risk triggering a catastrophic sovereign debt default. As mentioned last week, “The problem with policy quagmires isn’t knowing you should get out; it’s getting out….”

In 1958, economist Ludwig Von Mises wrote, “Nothing is inflationary except inflation, i.e., an increase in the quantity of money in circulation and credit…. And under present conditions nobody but the government can bring an inflation into being.” Well, governments by policy have been bringing “inflation into being.” There are indications that they have initiated a process that may be letting the inflation genie fully out of the bottle.

As first ballot hall of fame investor Paul Tudor Jones said this week on CNBC, “To me the number one issue facing main street investors is inflation. Inflation is not transitory, it’s here to stay, and it’s probably the single biggest threat to certain financial markets and probably, I think, to society in general.” At MWM, we are sympathetic, and continue to favor the opportunity and inflation protection offered by select hard assets and associated companies.

As for weekly performance: The S&P 500 closed the week up 1.64%. Gold was higher by 1.58%, while silver gained 4.71% on the week. Platinum was off by 0.64%, while palladium was lower by 1.97%. The HUI gold miners index put in a third consecutive positive week, up 1.66%. The IFRA iShares US Infrastructure ETF was up 0.98% for the week. Energy commodities were higher. WTI crude oil gained 1.80%, while natural gas was up 0.92% on the week. The CRB Commodity Index was lower by 0.64%, while copper dropped by 4.89%, retracing some of last week’s surge. The Dow Jones US Real Estate Index ended the week up 2.79%, while the Dow Jones Utility Average Index gained 2.55%. The dollar was slightly lower this week by 0.36% to close the week at 93.62. The yield on the 10-year Treasury increased by 7 bps to close the week at 1.66%.

Have a great weekend!

Best Regards,

David McAlvany
Chief Executive Officer
MWM LLC