February was an eventful (and in many ways disturbing) month and, on the investment side of things, provided a few important reminders.
1. When a fat tail (extreme and highly unlikely) event occurs, U.S. Treasury notes and bonds remain as the portfolio diversification powerhouse.
This chart shows the intraday price moves for the SPX (S&P 500 Index in blue) and TLT (iShares 20+ Year Treasury Bond ETF in purple). There is a clear pattern. When the S&P 500 Index declines, TLT increases in price. When the S&P 500 Index increases, TLP decreases in price. The negative correlation is readily apparent.
At Two Centuries Investments, we are often asked why we have an allocation to long maturity US Treasury bonds in our Dynamic Balanced asset allocation strategy when the economy appears to have entered an inflationary regime. The reason is diversification, especially when equities become richly valued and are thus susceptible to a crisis induced drawdown. If an event with severe economic implications occurs, then uncertainty will increase, liquidity will evaporate, and risky asset classes will suddenly become highly correlated. In such a high risk regime, US Treasuries exhibit the highly desired negative correlation with equities, even if the average correlation over time is positive. US Treasuries remain the flight to quality asset.
From our standpoint, US Treasuries make the asset allocation portfolio more robust and by extension help make investors more resilient, so they don’t sell in a panic.
2. Gold has some safe haven value in a crisis. Cryptocurrencies have many merits, but they did not act like investment safe havens over the last few weeks.
This chart shows the price performance of GLD (SPDR Gold Trust in gold), TLT (iShares 20+ Year Treasury Bond ETF in purple), SPX (the S&P 500 Index in dotted red), EEM (iShares MSCI Emerging Markets ETF in dotted orange), and GBTC (Grayscale Bitcoin Trust in dotted blue).
At Two Centuries Investments, we have a risk bucket for gold. We recognize gold does not generate cash flows and we like cash flow generating assets. Thus, we anticipate our models will often have a zero allocation to gold. We also acknowledge there is a faith based element to gold. However, gold has stood the test of time as an investment risk management tool. We sometimes think of it as “the hedge of the Treasury hedge.” Over the last few weeks, gold acted as if it was a hedge for geopolitical crises that may lead to an equity drawdown.
On the other hand, Bitcoin and other cryptocurrencies acted like risk assets. As you will notice in the chart above, when US equities started declining in February due to the Russia - Ukraine crisis, emerging markets equities declined even more. No surprise. However, Bitcoin declined on par with emerging markets equities. Gold rose in price similar to long maturity US Treasuries.
3. Reliable, readily available, low cost energy sources matter. A lot.
This chart shows the rise in the price of WTI crude futures (price of a barrel of oil) from $61.50 to over $110 in one year’s time.
This chart shows the massive spike beginning in late 2021 in the price of natural gas in Europe.
At Two Centuries Investments, we are big believers that intangible assets increase economic productivity and enhance company business performance. Our equity strategies (US, non-US, global) are based on intangibles. However, we recognize tangible assets matter too. None more so than energy commodities. Reliable, low cost energy sources free up labor and capital resources to focus on creativity, innovation and intangible assets. On the other side of the coin, higher energy costs are like sand in the gears of economic activity.
Higher oil and natural gas prices
reduce consumers disposable income
raise manufacturing costs
increase agricultural costs (natural gas is a feedstock for fertilizer)
raise mining costs for industrial metals
complicate the Federal Reserve’s plan to raise the Federal Funds Rate to suppress inflationary pressures
give geopolitical leverage to nations like Russia who are large oil and natural gas producers
The global economy is now experiencing a rapid decline in global oil inventories and a massive uptick in the price of crude oil and natural gas.
What drove the decline in inventories and the spike in prices?
1) Exploration and production companies cut back on capital spending to generate future supply. No surprise here, as “the cure for low prices is low prices”.
Publicly traded oil companies and their brethren, the national oil companies, suffered low return on invested capital (ROIC) in their pursuit of growth and market share. As a result, stock prices reflected the low ROIC. Over the seven years from February 2014 through February 2021, the oil and gas E&P industry underperformed the S&P 500 by 28% per year and the information technology sector by 37% per year. Ouch!
2) If poor stock price performance wasn’t enough of an incentive, politicians and ESG focused investors pressured companies to reduce oil exploration, thereby reducing their carbon footprint. These elements fueled additional cutbacks in capital spending. At the same the energy’s sector transition to renewable energy was slow.
Source: IEA
3) The economic lockdowns damaged global supply chains and the quick rebound in global economic activity meant labor and equipment could not be immediately tapped to expand oil production where it had been curtailed.
4) The secular increase in emerging markets energy demand was underestimated by almost everyone.
5) Europe underestimated the time and cost to successfully transition to a larger reliance on renewable sources of energy.
6) Several countries, Germany in particular, closed nuclear plants. From an energy density standpoint, only nuclear energy is superior to crude oil and natural gas.
7) Potential sanctions on Russia due to the Russia-Ukraine crisis created an additional supply shock in late February. Russia is one of the largest producers of oil and natural gas in the world. More critically, it is a major supplier of natural gas to Europe, in particular to Germany. Importing natural gas in liquified form from the US, Middle East and Asia is quite expensive due to high transportation costs.
4. Counterparty risk matters. A lot. Not just to the financial system but to global trade.
The move by some banks to hold back on issuing Letters of Credit for purchases of Russian commodities and goods will restrict the number of counterparties who can conduct trade with Russia. Further pressure on a complex, interconnected global trade system with few redundancies and struggling to find equilibrium after the pandemic induced shock represents a big risk. Recall September 2008, when it was the manifestation of counterparty risk that set off a downward spiral in the financial and economic systems.
There will be more volatility ahead. Returns will likely be lower than investors have become accustomed to during the almost thirteen year bull market. Equity investors may even face another large drawdown. Now is the time to reassess your risk tolerance and ensure you have adopted an overall portfolio strategy that will help you stay invested no matter what happens in the future.