Inflation & The Coming Gold, Silver, & Commodities Bull Run? w/ Tavi Costa (TIP553)

Name: Inflation & The Coming Gold, Silver, & Commodities Bull Run? w/ Tavi Costa (TIP553)
Uploaded: 2023-05-18T23:45:01.000Z
Duration: 2 h 54 min 58 s

Introduction

In this section, Clay Finck welcomes Tavi Costa to the show and introduces him as a guest.

Background Information

In this section, Clay Finck talks about how he discovered Tavi Costa's work and shares his admiration for some of the charts that Tavi has been posting.

The Most Important Macro Chart of This Decade

In this section, Clay Finck discusses the commodities to equity ratio chart with Tavi Costa.

Thesis on Why We're at the Beginning of an Uptrend for the Commodity to Equity Ratio

The commodities to equity ratio has been in decline since the great financial crisis.

Commodities have fallen relative to equities despite being underinvested in.

Declining interest rates have inflated prices of financial assets.

Tangible assets are cheap relative to financial assets.

Commodities have been underallocated by investors due to chronic underinvestment in the space.

Many commodities need new reserves and discoveries but lack capital expenditure.

Relationship Between Chart and Views About Inflation

The chart is a reflection of views about inflation.

Investors flocked into tangible assets during periods of inflation such as in the 1910s, 1940s, and 1970s.

Correlation Shift Between Tangible Assets and Equities

During periods of inflation, tangible assets such as housing markets perform better than stocks and bonds.

Investing in Commodities

Tavi Costa discusses how commodities are becoming a larger allocation of investors and how commodity businesses are part of this as well. He explains that there are many ways to express the view that commodities are undervalued in the markets.

The Value of Natural Resource Industries

Commodities and commodity businesses are undervalued relative to financial assets.

Lack of understanding and labor market issues contribute to price imbalances between equities and commodities.

Trends shown in this chart are secular trends, which tend to occur over a decade or so.

Geosciences undergraduates and graduate students have been in a secular decline.

Inflationary Forces

We may be entering a period of inflation running higher than historical standards due to liquidity injections and financial repression.

The four pillars of inflation include wages and salaries growth, wage prices spiral, cost of living rising, and supply chain disruptions.

Today's wage prices spiral is very similar to what we saw in the 1970s.

Second Wave of Inflation

History tells us that when inflation strikes, it can come back with a vengeance at some point later.

Recent liquidity issues with the banking situation were immediately mapped by Federal Reserve intervention, which is a liquidity injection in the system to avoid a liquidity gap otherwise.

Policymakers have one job: maintain stability of the financial system. This requires liquidity injections ultimately leading to periods of inflation running higher than historical standards.

Clay Finck on Inflation

Clay Finck asks Tavi Costa about the second wave of inflation and when it might be coming.

Second Wave of Inflation

Recent inflation started in early 2021 and peaked out in mid-2022, around 9.1% CPI here in the US.

We may be getting very close to a second wave of inflation due to liquidity injections and financial repression.

The four pillars of inflation include wages and salaries growth, wage prices spiral, cost of living rising, and supply chain disruptions.

Corporations and Natural Resources

In this section, Tavi Costa discusses three secular trends that he believes will impact the economy in the future.

Labor Costs

The share of labor costs relative to profits of corporations is historically low.

Corporations will not be able to get away with paying such low levels of wages and salaries relative to what they make.

The employment ratio across the less skilled part of the population in the US has never seen such a strong labor market throughout history.

This will create a higher demand for salaries to increase, which will play into this where the bottom 50% of the population financially speaking will probably be earning more money over time.

Natural Resource Businesses

Chronic under investments in natural resource businesses are causing commodity prices to rise due to supply side constraints.

There is a need for metals and availability for resources in order to make the green revolution happen.

It takes a long time for us to see the comeback of those investments into natural resource industries translate into higher supply.

Fiscal Spending

Reckless or irresponsible amount of fiscal spending that we’re seeing currently is partially due to increasing cost of debt creating a need for deficits to be larger than historical standards.

Interest payment on debt only explains about 50% of deficit today.

The Four Pillars of Inflation

Tavi Costa discusses the four pillars of inflation and how they will contribute to a secular inflationary period for the US and other developed economies.

The Four Pillars of Inflation

The first pillar is wages and salaries, which are increasing due to labor shortages.

The second pillar is natural resources underinvestment, which has led to supply chain disruptions and higher prices.

The third pillar is reckless fiscal spending, driven by social programs, military spending, and the Green Revolution.

The fourth pillar is deglobalization, which exacerbates inflation by creating changes in logistics and partnerships between countries.

Impact on Company Profitability

All four pillars are working against us in terms of preventing inflation from happening. This ties into company profitability and earnings.

Inflationary Thesis and Historical Earnings Per Share

Tavi Costa discusses the inflationary thesis and historical earnings per share on an aggregate basis in the S&P 500.

Historical Earnings Per Share

The S&P 500 has been in a 70-year channel in earnings per share on an aggregate basis.

Every time we hit the upper side of this band, we see a critical juncture in terms of earnings that tend to be in a contraction mode for the next few months or years.

It’s important to go back through our history again and analyze by decades because it’s a long-term analysis to reduce noise from different macro events that may have occurred.

There are two things that are important here. Firstly, the 2010s was by far the strongest real earnings growth that we’ve had in history.

Secondly, we’ve never seen two decades of robust growth in earnings straight.

Historical Comparison

The other two times we’ve had such robust growth happened during the Roaring Twenties and the 1990s.

After those two periods, corporations struggled significantly to earn capital.

The subsequent decade after those two were times when corporations struggled significantly to earn capital.

Future Outlook

Despite technological breakthroughs through AI and other incredible things that are being created recently, it’s hard to believe that corporate earnings will maintain their current growth over the next decade.

Operating Expenses and Margins

Tavi Costa discusses how operating expenses are likely to increase, causing margins to be squeezed significantly. He also talks about the decline in margins and earnings for corporations.

Factors Affecting Margins

Wages and salaries are a real problem, and with the current political agenda, it will force margins to be squeezed over time.

Material costs are likely to pressure margins due to underinvestment in commodities and natural resource industries.

Margins have declined from all-time highs before the global financial crisis and tech bust.

Tavi predicts an earnings recession as we're likely experiencing the beginning of a downturn in terms of earnings for most corporations.

Multiples During Inflationary Periods

Multiples of equity markets during inflationary periods average compressed significantly over 30% during those periods.

Valuations currently resemble periods like we've had in the tech bust or prior to the Great Depression.

It's difficult to maintain the same growth rate that we've had in the last decade, which questions again, the valuation of financial assets.

Conclusion

We're at a critical juncture where we're probably going to see a decline in earnings for all reasons mentioned above. If that's the case, it really questions again, the valuation of financial assets.

Gold and Yield Curve Inversions

In this section, the speakers discuss the role of gold and commodities in times of economic uncertainty, as well as the relationship between yield curve inversions and gold performance.

Gold Performance After Yield Curve Inversions

Historically, gold tends to outperform stocks over the 24 months after a yield curve inversion.

On average, on a relative basis, gold has increased by 72% after other inversions.

Yield curve inversions are a key indicator to watch for gold because they signal economic uncertainty and potential recession.

The percentage of yield curve inversions is a more comprehensive metric to analyze than just looking at one or two specific spreads.

Role of Gold in Times of Economic Uncertainty

During times of economic uncertainty, such as earnings compression or recession risk, gold and commodities can play an important role in portfolio diversification.

The speakers discuss how Howard Marks talks about interest rates no longer being at zero and how what worked in previous decades may not work now.

Limitations of Yield Curve Inversions

While yield curve inversions can be useful indicators for potential recessions, it's important to note that they don't always coincide with market declines.

The percentage of yield curve inversions is a more comprehensive metric to analyze than just looking at one or two specific spreads.

Overall, the speakers emphasize the importance of considering multiple factors when analyzing market trends and making investment decisions.

The Best Portfolio Position After the 70% Handle is Triggered

In this section, Tavi Costa discusses how he backtested different asset classes and found that the gold-to-S&P 500 ratio is the best portfolio position after the 70% handle is triggered. He explains that there are times when both gold and equity markets rise or fall together, but overall, precious metals could perform very well relative to equity markets.

Gold-to-S&P 500 Ratio

Backtesting different asset classes showed that the gold-to-S&P 500 ratio is by far the best portfolio position after the 70% handle is triggered.

The gold-to-S&P 500 ratio has been rising recently about 20% or so in average after two years from that 70% inversion.

There are times when both legs of this trade work very well, meaning gold rises with equity markets falling.

During stagflationary period in 1973,74 and during tech bust were periods where both legs of this trade worked very well.

Precious Metals as Defensive Assets

Tavi Costa believes there is a strong case to be made for why precious metals in general could perform very well relative to equity markets.

Investors need to stop looking at '08 as the only time in history that will replicate what likely will happen here because of potential recession or downturn in economy. They need to go back further and see what asset correlations we may have given structural changes we're seeing in macro drivers especially during inflationary periods like seventies.

Changing Portfolio Positioning

Tavi Costa believes that the 60/40 portfolios that we have today, the most popular portfolio positioning that we've had over the last 20-30 years, are not going to be popular 10 years from now.

He thinks they need to make room for things like gold and other commodities to be part of those portfolios.

Gold as a Defensive Asset

In this section, Tavi Costa discusses why gold is a defensive asset and how it can be used in portfolios.

Why Own Gold?

The risk perceived in the markets by owning Treasuries starts to change when Treasury yields rise.

There are three risks associated with owning Treasuries: default risk, inflation risk, and interest rate risk.

Today, these risks are strong counterarguments for owning US Treasuries as a defensive asset.

Large amounts of supply of treasuries may drive prices down due to deficits and less demand from central banks and institutions.

Gold is one of the most important ways to express the view that gold prices will go higher over time.

Why Not Just Own Gold?

Owning gold is not enough. It's truly a defensive asset that has a history and credibility in terms of being a defensive asset during periods when protection is needed.

During times of inflationary forces or higher cost of capital, gold can provide protection.

Asymmetric Ways to Express View on Gold Prices

There are many potential answers on how to express the view that gold prices will go higher over time.

Lack of discoveries and inefficiencies in smaller businesses make them an attractive investment opportunity.

The percentage of yield curing versions is an important macro indicator to look at.

Foreign Treasury Holdings

In this section, Tavi Costa discusses how foreign Treasury holdings play into his thesis and research.

The Dynamic of Foreign Treasury Holdings

Rising interest rates lead to falling US Treasury values, meaning that if foreign entities want to strengthen their balance sheets, then they better look for something that potentially stores its value a bit better.

China's US Treasury holdings have dropped from over 1.3 trillion in 2013 to approaching 900 billion today.

If we go back to the seventies again and understand what happened during that time period, it can help us understand how foreign Treasury holdings play into this thesis and research.

Central Banks and Currency Systems

Tavi Costa discusses the role of central banks in running a monetary system and how high-quality assets are required to back currencies.

Monetary System and Quality Assets

Central banks usually run a monetary system, but in the case of currency systems like the Euro or other international currencies, high-quality assets are required to back those currencies.

Gold used to be about 70% of those international reserves back in the seventies. However, after that period, there has been a decline in gold relative to other international reserves for almost 30 years.

Credible Central Banks

The most credible central banks in the world were the ones that bought treasuries and accumulated US treasuries over time.

More recently, given de-globalization trends, inflation issues, default issues starting to rise, questions about interest rates have arisen. All these questions are becoming more relevant over time.

Improving International Reserves

Most central banks now think about whether they should own debt from another indebted economy like owning US treasuries or own a neutral asset like gold that has a long history of being an asset that creates quality international reserves that a central bank requires to maintain credibility.

This is why we're seeing gold being purchased by most central banks recently at record levels as they try to improve the quality of their international reserves.

Financing Debt During War Time

Tavi Costa explains how leverage was an issue during war times and how individuals financed debt during this period.

Financing Debt During War Time

In the 1940s when leverage was an issue, individuals in the US were actually financing the war by buying war bonds. This was a significant portion of the demand driven by treasuries at that time.

The Fed instructed banks to buy US treasuries too, creating another demand for treasuries that is not the case as much today.

The Issue with Treasuries

Tavi Costa discusses the issue with treasuries and how it is one of the worst we have seen in history. He explains that the biggest issue with treasuries today has to do with the amount of treasury issuances that are happening in the market.

Treasury Issuances

The issues with treasuries are probably one of the worst we’ve seen in history.

The biggest issue with treasuries today has to do with the amount of treasury issuances that are happening in the market.

Recently, we’ve had something called the debt ceiling. That ceiling has been basically irrelevant for markets.

Assuming an agreement happens, how can the market absorb a large amount of treasury issuances once we do have that agreement in place?

Government Side

In terms of government side, which is very scary in general, but this is the case with every developed economy.

It’s not about whether they need to extend debt situation or not. They will ultimately extend it because otherwise everything is going to be collapsing and imploding in the US.

Treasury Cash Balance

The treasury cash balance today is running at one of its lowest levels in history. Today it’s at about 200 billion.

In March, 2022, fiscal deficit was over 300 billion. So, once an agreement happens and every time we’ve had a debt ceiling, you see a jump in treasuries outstanding.

Market Absorption

How will the market absorb? This is a very, very important question because we just went through 2022, which was a total collapse of the 60-40 belief.

The banking problem was really caused by collateral prices falling that caused a mismarking of those assets in their balance sheets.

The Importance of the Treasury Market

In this section, Tavi Costa discusses the importance of the Treasury market and its potential impact on the financial system.

The Buyer of Green Energy Bonds

Tavi questions whether individuals or green energy bonds will be buying these bonds at record levels. He thinks there is a high chance that we may see some big issues in the treasury markets sometime.

If the Treasury market causes turmoil, then the Fed is going to have to step in. This is what QE does - it buys those bonds, creating demand for those bonds and essentially monetizing debt.

Exploiting Issues in Order to Capitalize on Them

Investors need to think about how they can exploit issues related to the Treasury market in order to capitalize on them.

There are many trends that will be successful here, such as natural resources and value companies going back to understanding fundamental analysis.

Investing in Gold Miners

In this section, Tavi Costa talks about his thesis around gold and how he thinks about allocating capital towards gold miners.

Historical Context on Gold Space

To understand the gold space, you need some historical context on the industry too.

The biggest question institutional investors ask is why gold prices are making new highs but not seeing miners following suit.

Composition of Indices Driven by Larger Mines

Majority of indices that track gold miners use composition driven by larger mines like Barricks, Newmonts, Kinrosses of the world.

This does not reflect opportunity in this decade although they might do well for other reasons if gold prices rise.

Chronic Underperformance Across Majors

Chronic underperformance across majors has to do with how they're running their businesses.

If you look at just a chart of gold prices relative to revenues of those companies, you're going to find a major divergence where gold prices are rising and their revenues are not rising.

Aging Assets and Lack of Vision

The mining industry has aging assets with deteriorating quality, a lack of vision for growth, and no production growth happening across firms.

Decline in Production

Barrick’s gold production has seen a secular decline over the last decade.

Kinross and AngloGold have also experienced a decline in production.

Newmont's gold production has remained the same as it was 16 years ago.

Capital Allocation

Institutions are not interested in buying these assets because they are retiring over time.

Companies return capital back to shareholders at record levels instead of focusing on replenishing existing reserves or finding new discoveries.

Opportunity for Investors

There is an opportunity for investors to build the next Newmont or Barrick during this cycle by investing in small-cap names.

Quality companies and badly run companies are being priced at the same level today, creating opportunities for investors to find undervalued companies that may be onto major discoveries.

Exploration: A Path to Profitability

Most billionaires in the mining industry made their money on exploration. The creation of value during the speculation period of going from owning a property or mineral rights over that property to finding a major discovery is what makes most of the billionaires in this industry.

Exploration vs Production

Most capital made in this industry was actually made on exploration.

The increase of speculation, that creation of value that you build during that phase of the mining industry is what makes most of the billionaires in this industry.

Replicating the success of venture capital and private equity in general, which includes venture capital, could lead to success in mining exploration.

Investing in Mining Exploration

In this section, Tavi Costa discusses the potential for investing in mining exploration and how it can lead to significant returns.

The Opportunity of Investing in Mining Exploration

By investing in a hundred companies or so, one or two successful businesses can lead to significant returns.

Newmont is an example of a company that started as a fund and became one of the largest gold companies in the world by owning early-stage projects that turned into major discoveries.

There is a lack of understanding of the mining industry overall, leading to undervalued businesses with potential for success.

Understanding the Potential for Success

The statistically good ways to give conviction that there are major discoveries include drilling high-grade gold deposits several hundred meters deep.

Despite record-high gold prices, many mining properties are priced at depressed levels due to a lack of understanding and appreciation for their potential.

Major companies will have pressure from investors to improve the quality of their own reserves at some point.

Creating Wealth through Optionality

As the largest investor in high-grade, scalable, and economically viable discoveries, there is an opportunity to provide these assets to major companies or keep optionality open.

Investing in mining exploration is contrarian but offers an interesting way to asymmetrically tackle an opportunity with high conviction given macro views.

Continual learning about this space leads to portfolio improvement over time.

Investing in Silver and Brazil

In this section, Tavi Costa talks about his investment strategy for silver and Brazil. He discusses the benefits of purchasing a silver mine and investing in Brazil as an emerging market.

Purchasing a Silver Mine

Tavi Costa recently purchased the seventh-largest silver mine in the world.

This was a leverage buyout that allows him to leverage up his trade.

Every dollar that silver goes higher, the free cash flow of this mine goes up by 15 to $20 million.

Tavi believes that if gold or silver prices reach triple digits one day, which he thinks is not out of reality, then they will make new highs and historical highs.

Investing in Brazil

Tavi's fund is invested in Brazil because it is a small market to spread your wings around, especially if you're a large institution looking to find significant exposure.

As institutional investors look for countries likely to benefit from long commodity views in the markets, they will turn towards emerging markets like Brazil.

Emerging markets are very different from each other. The BRIC countries are not a block of economy but rather segregated and very different in nature.

India is less of a geopolitical mass than China or Russia but it's still a net commodity importer while Brazil has its own unique environment.

Brazil's Natural Resource Economy

In this section, the speaker discusses how most of the Brazilian economy is related to natural resources and how it is neutral in terms of geopolitics.

Brazil as a Commodity-Led Economy

Brazil sells things to China, the US, and Russia due to its neutrality.

The speaker was initially skeptical about investing in Brazil due to political leadership and corruption scandals over the last 30 years.

However, understanding commodity markets and the likelihood of a commodity cycle made him bullish on investing in Brazil.

The Brazilian market attracts investors because of its positive backdrop for tangible assets, specifically commodities.

Investing Opportunities in Brazil

In this section, the speaker talks about investment opportunities in Brazil and South America.

Undervalued Assets in Brazil

Banks operating in Brazil should be impacted by a commodity bull market indirectly.

The banking industry does very well during periods when commodities perform better than other periods.

Investing in undervalued assets requires a change in allocation but has potential for exponential returns.

Risk is present but reward is mispriced relative to risk.

Investment Opportunities Beyond Brazil

There is a strong correlation between world commodity producers and the Brazilian equity market.

Bolivia is opening up their economy similar to Peru back in the nineties which became a hot market for mining space driven by openness to foreign investors.

The Economic and Political Environment in South America

In this section, Tavi Costa discusses the relationship between the economic and political environment in South America. He explains how the economic side usually leads the way, citing Venezuela as an example of how a collapse in energy prices exacerbated by political unrest led to a populist authoritarian agenda. He also shares his views on why he believes Brazil is likely to benefit tremendously from commodity trends.

Relationship between Economic and Political Environment

People tend to focus more on the political side rather than the economic side.

The collapse of energy prices in Venezuela created a narrative for populism that worsened the political environment.

Social unrest and populism can arise due to inflationary pressure caused by currency devaluation.

China may face social unrest, major currency devaluation, and a shift in political environment if commodity prices rise drastically different than what everyone thinks.

Brazil's Potential Benefit from Commodity Trends

Brazil is likely to benefit tremendously from commodity trends.

It's important to consider commodity-led economies versus commodity importers.

There are similarities with early 2000 when Lula became president during a commodity bull market.

Brazilian assets are asymmetric opportunities that can be owned as part of a portfolio.

Conclusion

Tavi Costa shares his work on Twitter @TaviCosta where he elaborates more on his views.

More in-depth research about macro environments can be found at kreske.net Krest.

Crescat Capital runs three funds: a global macro fund, a long-short fund, and a precious metals-focused fund. They will be launching a commodity institutional fund soon.

Macro Investing Opportunities

In this section, Tavi Costa discusses macro investing opportunities and shares some ideas for investors.

Macro Investing Opportunities

Tavi Costa believes that there are a lot of opportunities to be a macro investor today.

He is excited about the future and hopes to provide good ideas for investors in general.

Costa mentions that his team has been successful over the years in the space and they are proud of it.

He suggests that big macro trends being unleashed in this environment present many opportunities for macro investors.

Conclusion

Clay Finck thanks Tavi Costa for sharing his insights and providing great ideas for investors.

Finck appreciates all the free content that Costa puts out, especially on Twitter.