Record Liquidity vs Depression-Level Economic Activity
With over 30 million American jobs lost since the outbreak of the Coronavirus pandemic, the U.S. economy is reeling from an unprecedented economic shock – even surpassing that of the Great Depression.
And yet, despite depression-level economic activity, U.S. equity indices like the Invesco Nasdaq-100 ETF (QQQ) have now rallied into positive territory on the year. Why? Look no further than the unprecedented $6 trillion (and counting) of combined monetary and fiscal stimulus. As the great Stanley Druckenmiller once explained:
Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity.
We can see exactly how much influence the Fed’s liquidity operations have had on financial assets through the lens of four key monetary policy actions over the last 18 months, including:
1) October 1, 2018: The Fed’s quantitative tightening campaign accelerates to $50 billion in monthly asset sales. Stocks decline by 20% and enter bear market territory over the next three months.
2) January 4th, 2019: The Fed capitulates on further monetary tightening, and sets the stage for a return to easy money policies, starting with Fed Chair Jay Powell’s “patient” speech. Stocks bottom and proceed to new record highs.
3) October 11, 2019: The Fed announces $60 billion in monthly Treasury purchases via “Not QE” in response to the September “Repo Crisis”. Stocks gap higher on the day and enjoy a nearly uninterrupted 25% rally until the Coronavirus-inspired market meltdown in late February.
4) March 23, 2020: The Fed announces “unlimited QE”. Stocks bottom on the day, and proceed to rally over 30% as tens of millions of Americans lose jobs and the economy grinds to a halt.
The chart below shows how the Nasdaq-100 (QQQ) has responded to each of these key events:
In short, the old axiom “don’t fight the Fed” remains the tried and true guide for navigating today’s brave new world of central bank-sponsored financial markets.
So while the $6 trillion and counting of Fed + Treasury stimulus will likely put a floor under risk assets, it’s unlikely that the old playbook of simply going long the broad market indices will provide the same easy risk/return proposition of the last decade. The reason: starting valuations matter… and most of the large/mega-cap stocks holding up the broad market indices like the Nasdaq-100 (QQQ) are not only priced for perfection, but face meaningful headwinds to their core businesses going forward.
Think of stocks like Apple (AAPL) and Microsoft (MSFT), trading at 25 – 30x trailing earnings, with significant downside risks to future earnings as consumers and businesses pull back on spending. Meanwhile, other high-fliers like Netflix (NFLX) and Tesla (TSLA) suffer from perpetual cash-burning business models and bloated balance sheets – structural problems that aren’t going away, or will likely be exacerbated, in a global economic downturn.
In short, simply avoiding a crash doesn’t translate into substantial upside given today’s stretched valuations and bleak fundamentals for many of the largest companies holding up the stock indices. Instead, I believe we’re entering the first inning of what will increasingly become a stock picker’s market, where vast divergences in underlying fundamentals and starting valuations across different sectors will make for an increasingly bifurcated market going forward.
In this article, I’ll explain why two sectors – precious metals and U.S. natural gas producers – offer the potential for significant outperformance in today’s environment of contracting economic growth and record monetary stimulus.
The No-Brainer Trade of the 2020s: Precious Metals
You only need two simple charts to appreciate the massive tail-winds for the price of precious metals, like gold (GLD) and silver (SLV), starting with the unprecedented expansion of the Fed’s balance sheet:
Since the launch of “not QE” last September, the Fed’s balance sheet – the foundation of the U.S. monetary base – has surged by over 70% from $3.8 trillion to $6.6 trillion today. And unlike previous iterations of QE, where the money flowed mostly into financial assets, this time around much of the new money is finding its way into the real economy – evidenced by the explosive growth in M2 money stock, currently running at a record pace of more than 15% annually:
Going forward, we have every reason to expect further aggressive money supply expansion from the Fed, in order to monetize the structural rise in U.S. deficits. First, let’s simply consider the trajectory of U.S. deficits even before the Coronavirus pandemic.
The chart below comes from the December 2019 Congressional Budget Office (CBO) report, which shows how U.S. deficits have already more than doubled from under $500 billion 2015 to over $1 trillion in 2019, and were already track to steadily increase towards $1.5 trillion annual deficits by the end of the decade even before factoring in a Coronavirus-inspired default cycle and recession:
Critically, these CBO deficit projections in the chart above reflected the incredibly optimistic assumption of uninterrupted economic growth for the entire next decade. But we can safely throw those projections out the window, with the Coronavirus outbreak delivering the one-two punch of plunging tax revenues and hundreds of billions in bailout programs. Current estimates from the Trump administration show that the 2020 U.S. deficit will quadruple to nearly $4 trillion.
The bottom line: the fundamental driver for exploding U.S. deficits, and thus an exploding Fed balance sheet, has never looked more bullish both in the short or long-term. That’s why I’m projecting the Fed’s balance sheet will likely head towards $10 trillion within the next couple of years, and bring along with it new record highs in both gold and silver prices.
Of course, countless investors and pundits have pointed out that gold underperformed during the previous 10-year bull market in equities, and also sold off alongside stocks during recent Coronavirus-inspired market crash.
But this first point ignores the previous 15-years, where gold massively outperformed U.S. equities. After 15-years of nearly uninterrupted gains in gold – a period where stocks suffered two 50% declines – a correction was perfectly normal and to be expected.
Regarding the second point, gold isn’t supposed to provide a hedge against short-term market volatility… instead, it’s a hedge against the long-term debasement of fiat currency. In that context, the yellow metal has performed its role flawlessly over the last couple decades.
If we zoom out to the dawn of the modern era of central bank activism – the first major Wall Street bailouts during the 1998 LTCM/Asian Financial Crisis – gold has done a much better job of protecting wealth versus the broader stock market – outperforming by several hundred percent:
So while the aggressive fiscal/monetary response to the current Coronavirus outbreak will likely put a floor under the broader stock market, history shows that gold offers an even better hedge against U.S. Dollar devaluation going forward. That’s why I expect gold’s secular outperformance of U.S. equities to not only continue, but accelerate in the coming decade.
Playing on that same theme, certain mining/streaming companies offer potential outperformance of gold itself. Companies like Sandstorm Gold (SAND), which spent much of the previous gold bear market building out an impressive portfolio of growth projects, by making scores of streaming deals to finance cash-strapped mining companies.
Not only have Sandstorm’s streaming volumes more than doubled from the last peak in gold prices back in 2012, but those volumes will more than double again over the next five years. Looking out to the early 2020s, I expect Sandstorm will produce more than triple the streaming volume and profitability reached during the last bull market peak in 2012, while also enjoying sustained higher gold prices as well.
With SAND recently breaking above key resistance at $8 per share, I see little resistance in the way of new all-time highs above $15 in the not-distant future. And with gold prices averaging around $2,500 per ounce in the next several years (my conservative estimate), I believe shares could rally to $50 from the combination of higher gold prices and additional streaming volumes coming online:
Natural Gas: The Anti-Recession Trade
Next on the list, the long-awaited natural gas (UNG) bull market appears to be upon us. On the surface, that may seem premature given current spot prices below $2 per Mcf, but that will likely soon change given the collapse in oil demand, which will bring about a collapse in oil production, and thus a reversal of the biggest headwind facing the sector in recent years: associated gas from oil drillers. Let’s start with the oil demand side of the equation…
With global transport collapsing in response to the Coronavirus outbreak, oil demand is down roughly 20 – 30% depending on which estimate you use. Thus, global oil inventories have not only reached record highs, but they’re also building at a record rate – vastly exceeding the supply/demand imbalance seen during the 2015-2016 price crash:
Commodity analysts at Goldman Sachs currently expect global oil storage capacity to be reached within 3 – 4 weeks. With nowhere to put the excess supply once storage fills up, Goldman expects the situation will force a roughly 20% cut in production among global producers. U.S. shale drillers will likely make up a meaningful share of this forced global production cut.
Now, the thing about shutting in shale wells, is that we’re not talking about flipping a light switch on/off. Shutting in production in many shale formations risks creating significant long-term reservoir damage … or at the very least, losing reservoir pressure over time, and thus incurring a meaningful drop off in production rates if/when the wells open back up. Meanwhile, costs of production will rise given the decimation in oilfield service capacity (which will also prove long-term bullish for leading service companies like Schlumberger (SLB), to be revisited in future articles).
So even in a best-case scenario where oil demand enjoys a v-shaped bottom if/when the economic recovery kicks in, I’m not betting on a v-shaped recovery in U.S. shale oil production anytime soon. The June 2021 oil futures contract hovering just above $30 per barrel confirms this view that the global glut will not likely improve anytime soon:
So while gas rigs have been in persistent retreat for over a year now – given capital retreat from investors and lenders – the Coronavirus situation has forced similar capital retreat from the oil patch at a record pace. Today, the combined U.S. oil + gas rig count is quickly approaching the 2016 lows, and I wouldn’t be surprised if we overshoot those lows on the downside in the weeks ahead – particularly in the oil count, given the unprecedented storage crisis that will unfold in the coming weeks:
And unlike the previous 2015 – 2016 energy collapse, where private equity investors deployed over a hundred billion dollars in funding to inspire a v-shaped production rebound, we’re seeing the exact opposite dynamics in 2020: massive capital retreat as detailed in the graphic below:
Thus, we have every reason to expect a meaningful drop in gas production within the next 6 – 12 months. The EIA is currently projecting a 10 Bcf/d drop in gas supply by mid-2021, but that could turn out to be conservative, depending on how the funding environment and oil storage situation unfolds from here.
Meanwhile, gas demand remains relatively robust during recessions. Why? Well, when was the last time you stopped using electricity or heating/cooling your home during a recession? So whereas oil consumption has dropped by 20 – 30%, we’re currently setting new record highs for seasonal gas consumption:
Source: Tableau Public and @RonH999 on Twitter
Now, the key gas consumption factor – electricity – isn’t 100% immune from economic activity. New York City, the epicenter of the Coronavirus outbreak in the U.S., has suffered a double digit decline in power demand in recent weeks. But U.S. gas demand is holding up remarkably well thanks to low prices accelerating the secular shift in fuel mix from coal to gas-fired power generation. As S&P Global Platts reports, U.S. coal-fired power generation is down roughly 30% year-over-year, compared with gas-fired power generation running 14% above last year’s levels.
Meanwhile, thanks to the global LNG glut keeping gas prices depressed throughout Europe and Asia, we’re seeing a similar acceleration in this trend away from coal towards gas-fired power generation globally, as detailed in this Bloomberg article.
Thus, the current short-term oversupply in both the U.S. and overseas gas markets is a positive long-term development that will accelerate the ongoing global transition from coal to gas-fired power generation. All else equal, it’s much more beneficial to suffer through a few more months of low spot prices to capture the incremental secular demand growth that will come from shutting down global coal capacity.
So despite the potential for some modest LNG shut-ins over the next few months, I believe the market is correct in pricing in a significantly tighter gas market next year, with nearly every contract across the 2021 futures curve rallying for the last seven weeks in a row. The key price I’m watching on a daily basis is the June 2021 contract, which is on the verge of breaking above the 200-week moving average for the first time in nearly a decade:
The bottom line: the U.S. natural gas sector enjoys a unique degree of resilience in today’s equity market. Any short-term weakness that keeps the front-month prices depressed only sets the stage for more secular growth in the ongoing global shift from coal to gas-fired power generation. Meanwhile, the weaker the economy stays, the more supply destruction we can count of from the oil patch, which in turn means less associated gas supply – the single biggest source of gas supply growth in recent years. In short, it’s the ultimate anti-recession trade.
With gas prices averaging around $2.70 across the 2021 futures curve, companies like Range Resources (NYSE:RRC) should continue re-rating from distressed equities to cash generators in the weeks and months ahead. My fair value estimate for RRC in an environment of $2.70 gas is well into the teens… and based on the chart alone, we have plenty of open space with little resistance until at least the $9 – $10 level:
In summary, gold and natural gas offer two sectors that can continue benefiting not just despite ongoing economic weakness, but because of it.
Subscribers interested in regular updates on these and other ideas can find weekly updates at the Atlas Research blog. I’m currently tracking a live portfolio, including option trading strategies, including a Range Resources (RRC) option trade published on April 6th, which has returned 1,500% as of closing prices on Wednesday, April 29th. In the coming weeks, I’ll be launching a marketplace service that will provide similar investment and trade ideas.
Stay tuned and subscribe for future updates!
Disclosure: I am/we are long RRC AND SAND. 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.
Additional disclosure: I’m long RRC and SAND via call options