The one buzzword most associated with economic conditions and the volatility plaguing the stock and bond market in the first half of 2022 is inflation.
We will not use this blog to pile onto the available analysis and punditry about the sources of high inflation or to speculate about its future course. Instead, we will focus on the investment lessons revealed by the inflation of 2022 that contain useful principles for investors navigating any number of future macroeconomic situations.
In volatile times, we believe that to give themselves the best opportunity to protect capital, if not to make outright gains, investors must have a Bayesian approach to thinking about investments. Without wandering too deeply into the complexities of Bayesian mathematical theory, we can summarize the Bayesian approach as allowing for new evidence to have a defined impact on forecasts made using prior knowledge.
This may seem like an obvious approach. Many investors would say, of course, if there is new evidence that I did not previously consider, I will add it to my model and change my mind if I must. But many investors become rigid in their thinking, weary of allowing any bias to enter their thesis once it has been formulated. In other cases, the uncertainty of investing may lead some investors to nervously cling to historical analogies or models, providing a potentially false sense of security. It is popular among investors to mock the sentiment, “This time is different.” But when historical analogies are taken too far, key determinants can be exempted from decision-making, or their importance can be minimized as to not alter the final thesis.
For the Axiom Investment Team, the frameworks we use to make allocation decisions typically sound something like:
“This time is similar to another time, but there are several important factors that could end up making it completely different.”
Historical analogies are a useful tool for forecasting the likely course of financial markets. History is full of lessons, and under similar circumstances capitalism leads to similar outcomes. But modern novelties can present unanticipated risks for investment ideas that originate in historical analysis, so we are careful to identify and consider new evidence.
As an example, consider how the metals and mining stocks traded in the first half of 2022. The roughly 3% loss through June 30 in the SPDR Metals & Mining ETF (NYSE: XME) belies a volatile six months of trading. The exchange traded fund seeks to track the performance of the S&P Metals & Mining Select Industry Index, with components including a diverse mix of miners, such as rare earths miner MP Materials Corp, gold miners like Newmont and Royal Gold, and steel, aluminum, and copper miners like Freeport-McMoRan, Nucor, and Cleveland-Cliffs. After declining approximately 10% through January, the index exploded more than 60% higher as global inflation accelerated. The war in Ukraine fueled the rally further, squeezing supply of many important metals and lifting forecasts for prices.
The rally rewarded many early investors who noticed inflation accelerating and looked to the inflationary period of the 1970s for clues about where to invest. Indeed, it is intuitive that metals and mining stocks will perform well in an inflationary environment, as strong pricing leads to higher margins and faster earnings growth. As has already happened in the current environment according to analysis of the last few quarters of earnings, the price takers of commodities in the 1970s saw their margins squeezed, while the price makers, the miners and oil drillers, saw handsome profit margins and strong earnings growth, rewarding their shareholders.
Why, then, did the metals and mining stocks see their year-to-date gains – tallying nearly 50% in April – entirely wiped out by June 23? War in Ukraine persists. The most recent inflation report was surprisingly high. If supply shortages have improved in certain markets, it appears to have been minimal. And yet, the metals and mining ETF corrected over 35% tip to tail.
In Axiom’s view, the answer lies in the factor that made it different this time (at least for now). For much of the 1970s, the Federal Reserve allowed the economy to run hot, resisting taking the austere policy necessary to quell inflation until Chair Paul Volcker’s appointment in 1979.
Given the scale of accommodation the Federal Reserve provided the economy during the Coronavirus pandemic and what many critics regard as a policy mistake in delaying the removal of this accommodation during 2021, each accelerating inflation data point of 2022 has brought the Fed’s credibility further into question. With the 1970s providing a lesson of what not to do, Chair Jerome Powell and the Fed Board of Governors have signaled increasingly hawkish policy. This culminated in early June, as another surprisingly hot inflation number drove the Federal Reserve to hike interest rates 75 basis points, 25 basis points above expectations leading up to the meeting and certainly higher than what could have been expected by investors buying metals and mining stocks in the first few months of the year.
Some complacent commodity investors, with portfolios full of winners and strong gains in April, saw their investment theses confirmed by hot inflation surprises and strong earnings forecasts from many companies in the sectors they invested in. But the stock market is concerned with future earnings, and increasingly hot inflation data paired with the rising chorus of criticism for the Federal Reserve was a warning sign for investors. It is well known that the longer inflation persists in the economy, the more entrenched it becomes and the harder it is to solve.
Like the 1970s, inflation is running hot. But, at least according to recent Federal Reserve actions and statements, the difference this time around is that the Federal Reserve appears determined to bring inflation down to their target, even if it means triggering a recession through austere policy. For metals and mining stocks, this could mean a period of destruction of demand and weaker pricing. As is often the case, the stock market began to price this increased possibility several months in advance.
Of course, this is subject to change. The economy could avoid recession, and, in our view, long-term demand for many metals has reason to be strong, including infrastructure buildout and industrial advancements in energy, transportation and electrification. But the wide swings in metals and mining stocks through halftime of 2022 are a reminder that investors must be open-minded and flexible, on the lookout for opportunities but even more vigilant in considering risks to even their most profitable winners. Without a Bayesian approach, gains could disappear as quickly as they came.