Dylan Grice, co-founder of Calderwood Capital, sees frothiness all over today's financial markets. He thinks valuations in hot sectors like electric vehicles are insane, but he sees investment opportunities in areas like uranium and oil.
Dylan Grice is concerned. The co-founder of Calderwood Capital and former strategist at Société Générale sees smaller and larger bubbles emerging all over financial markets. «There are clear signs of excess», says the author of the monthly «Popular Delusions» report.
Still, Grice characterizes his current investment stance as reluctantly bullish: «Central banks will overcook the economy, everything is set for a few years of overstimulation in monetary and fiscal policy.» This won't end well, he adds, but until then the equity market boom could continue.
In an in-depth conversation with The Market NZZ, Grice explains how investors could navigate the current environment and where attractive investment opportunities still exist. Grice is particularly bullish on the uranium and oil & gas sectors.
Mr. Grice, in your latest Popular Delusions report, you call yourself «reluctantly bullish». Why?
I like to feel that if I’m underwriting risk, I’m getting well paid for it. And right now I don’t think that’s the case. It doesn’t really matter which segment of the market you look at, risk premia are almost universally tight. Risk premia are back to where they were pre-Covid, in some cases even tighter, and they were already unattractive before.
So if you put on your value investor hat, you can’t see any value?
Generally not. There isn’t any broad value except for some specific pockets. Back in March of last year, we were very bullish. To be clear, that was not because we thought we could identify the bottom, but because we could see panic and dislocation. It is a core belief of mine that you have to take the other side of a market that is in panic selling mode. That’s when you have to be buying.
Many investors were surprised by the strong recovery that has taken place since. What did you make of that?
We remained bullish in the months after March, because you could see that everyone hated the rally. Twitter was full of people who were angry. Angry that the Fed had injected money into markets, angry that the Fed had created all sorts of distortions. All of these arguments, which I have quite some sympathy for, were irrelevant to the investment case. As an investor you must not blind yourself with what you think policy makers should do. You must look at what policy makers are doing, and instead of making a moral judgement on whether that’s good or bad, you have to understand what the consequences of those policy actions are. This anger clouded the judgement of many investors. So, I was happy to be bullish throughout this period.
What has changed now?
My reluctance is because I feel it’s all incredibly frothy now. There are signs of excess, and yet we are still in the middle of a pandemic, we haven’t even started the economic recovery yet.
What signs of excess?
I think that this GameStop fiasco is kind of an indication of wider problems. Also when I look at the exuberance in hot sectors like electric vehicles, which investors seem to forget is a very capital intensive business. Valuations there are crazy, this is getting demonstrably insane. I would completely avoid that. This is not the kind of market which a fundamentally value driven investor should be bullish of.
Is the boom in SPAC issues also a sign of excess to you?
I don’t have an opinion on the SPAC market, I just don’t know enough about it. I know some very smart investors who are investing in it. But I can also see that this is a market which is potentially designed to fuel excesses, given the fact that investors give SPACs money without asking any questions. It reminds me of the Initial Coin Offerings a few years ago. The SPAC sector has the potential to become an enormous bubble, even if it isn’t one at the moment.
Despite your reluctance, you say you are bullish. Why?
Because I think central banks are going to overcook the economy. Ever since Jackson Hole in August, Fed chairman Jerome Powell has made it very clear that they are going to push the economy harder than they have in the past. Powell, in several speeches, has emphasized how devastating it is for low income communities to have high unemployment. The Fed considers it its mandate to make sure that these communities have jobs. Therefore the Fed believes it is doing a good thing by running the economy harder than it has in the past.
They are willingly inflating a bubble?
The Fed sees it as its mandate to create jobs. Consumer price inflation is of no concern to them right now. I can’t imagine a clearer setup for an overheating economy and financial market bubbles. During the GameStop fiasco, Powell was asked repeatedly what he thought of this kind of froth. He said this has nothing to do with the Fed. So, in terms of monetary policy, everything is set for a few years of overstimulation.
And the same thing is happening on the fiscal side, right?
Exactly. Joe Biden is talking about $1.9 trillion worth of stimulus, after we already had $3 trillion last year, which makes it $5 trillion in total. That’s an insane number, about 25% of GDP. There already is an enormous amount of pent-up demand, money that is waiting to be spent. Normally, when you get an overcooked economy and you get inflation, the Fed would step on the brakes. But this time, the Fed has said repeatedly that they will not step on the brakes. So I think the risks here are on the right tail, not on the left tail. This is not a market to be short of.
In a nutshell, you paint a scenario of monetary and fiscal overstimulation, which means this equity market boom could run much further than it already has?
Yes. This is not a big, market wide bubble yet, but we are getting there. And to be very clear, that’s not a good thing. This actually makes me very nervous. Bubbles burst, they always do. We have all these societal cracks that became painfully visible after the Global Financial Crisis of 2008, and central banks just keep blowing up new bubbles to paper over these cracks. This is incredibly dangerous, because inevitably these bubbles burst, and the bandage on the societal cracks rips open again, with the fragmentation, polarization and distrust within our society deepening further.
This pattern, blowing up a new bubble after a previous bubble had burst, has repeated itself several times in the past three decades. What will be the end game of this?
There is no end game, there’s just a cycle. Right now people’s faith in the system is in decline. Trust in institutions – the media, politicians, the «elites» – is in decline, and it seems like distrust is just going to deepen further. What I worry about is what kind of trigger will be necessary to snap us out of this long social panic we’re in, and to start building trust again. I hope it’s not something as extreme as a war.
How do you at Calderwood invest in this kind of environment?
The fund we run at Calderwood is a different animal. We specifically avoid equities, anything like equities, and nearly all bonds. We have found there are plenty of managers running highly specialized, niche strategies which generate extremely attractive returns without being correlated to wider financial markets, or being subject to any of the risks we’ve just been talking about. Investors in traditional assets – public equity, private equity, venture, government bonds, corporate credit – are sitting on a time bomb. They have to keep their fingers crossed and hope that bomb doesn’t go off on their watch. If and when government bond yields rise, the traditional assets which have done so well will be smoked.
Do you see the risk of a bond market sell-off, with yields shooting up, which would put an end to the frenzy?
I think at some point the Fed will just step in. They can’t afford to let yields rise too high, because the likelihood of some kind of liquidity event would increase massively. They can’t afford that. So the next stage in the logic of what the Fed is doing would be that they step in and control yields, to prevent them from rising too far, too fast.
You mentioned there are very few pockets of value left. Which ones?
Areas I still like are uranium, oil & gas plus some frontier markets like Bangladesh.
What’s your case for uranium?
Uranium is a scarce commodity, not really correlated with other commodities, because of its unique demand pattern. Nuclear power plant operators typically buy uranium through five to seven year contracts, which means its price does not swing around the economic cycle the way copper or oil do. The price cycle for uranium is driven by the usual, well-known mining cycle. It takes five to ten years to bring new mine supply to the market, and we have long cycles of overinvestment and underinvestment. So far, nothing new. We had a big bull market in uranium in the early 2000s, all the way to March 2011.
Until the Fukushima quake?
Exactly. Fukushima changed everything. It scared everyone to death. The Japanese shut down their reactors, the Germans decided to exit nuclear energy, and so on. We got a kind of a nuclear winter in the uranium mining industry, if you pardon the pun. There was absolutely no investment in mining capacity in the past ten years. Nuclear power generation suddenly was seen as an industry that has no future. Therefore, the commodity cycle turned down in its most vicious form. The mining industry was cut off from any funding. When you see this pattern, a commodity where no one has invested for ten years, you have the setup for a new bull market.
Was the market wrong in its assessment that nuclear power has no future?
Absolutely. That industry has a future. Japan is now using nuclear power again. Globally, the number of nuclear power stations in commission is higher than ever, the pipeline for new projects in North America, China and India is at record levels. The demand for nuclear power is growing, regardless of what the Germans, Swedes and Swiss are doing. I’m not saying anything about whether nuclear is good or bad, I’m just looking at the world as it is: Short uranium, and going into a period of rapid demand growth for uranium. Although, personally, I think that if you want a decarbonized environment, you’re not getting there without nuclear. Nuclear is a perfect case study of the public misperception of risk.
How do you mean that?
We humans have an inability to correctly evaluate a risk once we can associate it with a very salient image. The classic example would be the number of excess car accident deaths after people suddenly got afraid of flying after 9/11. In terms of nuclear power, the salient image we have is Chernobyl, which was undoubtedly a disaster. But we have to remember that the Chernobyl reactors were barely first generation, they didn’t even have the very standard protective measures that today’s reactors have. They don’t even compare. This was the Wright Brothers aeroplane compared to the latest fighter jet. You know what was the biggest power generating accident in history? A dam that burst in China in 1947, killing 147’000. We know it could be disastrous if a dam breaks, but people are okay with it. Hydro is seen as green and sustainable. True, but nuclear is green and sustainable too. So if you care about the environment, you should be in favor of nuclear power.
In Europe, at least, this remains a tough sell.
I know. But again, just look at the commissioning of new nuclear power plants, the pipeline for the next ten to twenty years, it’s off the charts. Demand for uranium is going to grow, and there have been no new mining investments for ten years. This is where explosive commodity bull markets come from.
A multi-year period of declining investment in new production: Is that your bull case for oil, too?
Yes. Pretty much all the majors have cut their capex plans. One image perfectly encapsulates financial markets’ view of the energy sector: The market cap of Tesla today is roughly the same size as that of the entire S&P 500 oil sector, which includes the majors, the independents, the drillers, the service companies and the refiners. The equity market’s view seems clear: Oil has no future, the energy transition is here.
And you’d say that’s not the case?
The energy transition is real, but it’s moving at a glacial pace. The annual Electric Vehicle Outlook summary by Bloomberg projects that EVs will only make up around 8% of the total fleet of passenger cars by 2030. The number of cars is expected to rise from today’s 1.2 billion vehicles to 1.4 billion, but only about 110 million of them will be EVs. So the number of internal combustion engine vehicles by then will be around 1.3 billion, which implies a forecast rise of around 0.7% per year. Moreover, while passenger vehicles contribute around 60% of the global demand for crude oil, the rest comes from heavy duty vehicles, aviation and the petrochemicals industry for which there are, as yet, few alternatives. I’m not saying that this is something I’m particularly happy about, but my job is to allocate capital according to the way the world is, not according to the way I want the world to be. Oil will continue to play a central role in the global economy for decades.
So we're talking about a misperception of the market?
The market was behaving as if oil was dead. But it won’t be, not for a long time. A second important fact is that the energy transition is a risk which is widely recognized and understood. No manager in the oil business is under any delusion about the reality of the industry. Hence they are scaling down the ambitiousness of their investment projects. A squeeze is coming.
Yet more and more investors won’t touch the fossil energy sector anymore. What do you make of this?
It just makes me more bullish. Oil has been starved of capital, the whole mantra of the industry is that they are not going to grow anymore, they preserve cash and return it to shareholders. Even the American shale producers, who easily have the worst track record when it comes to capital allocation, have got this new religion. This is a bull market in the making. It’s just obvious.
You don’t see the risk of a permanent ESG discount in energy stocks?
I want to live in a clean world, I want my kids to live in a clean world, I want to see a decarbonized world. I have enormous sympathy for the whole ESG thing. But I also happen to think that as an investor, you can’t serve two masters at once. Tobacco is a good example: It became clear in the seventies that smoking causes cancer. It became known that the tobacco companies had been lying about studies, they had been dreadful and corrupt. Suppose you had refused to invest in tobacco stocks back then. On an ethical scorecard, you’ve managed to signal your virtue to everyone. But as an investor, you missed out on a compound return of 20% per year over the next four decades. Tobacco was the best investment during those decades, and the reason for that was because it traded at such a deep discount to fair value because people had moral qualms about purchasing it. And by the way, refusing to own tobacco stocks didn’t stop people from smoking.
So big oil is what big tobacco was in the seventies?
It’s an analogy, and we shouldn’t stretch it too far. The fact is, despite all the capital that’s going to electric vehicles, and despite the crazy stock market valuation of these companies, they are probably not even going to be 10% of the entire stock of on-road passenger vehicles in ten years time. Which means demand for oil is going to grow. I personally happen to think that this is bad for our planet, and I don’t want to fund these companies. But if I go and buy oil drillers, or if I buy Exxon, if I buy their shares on the secondary market, I haven’t given them any money. The people who use oil have funded them, by driving cars, flying in planes and using plastics. That’s the problem to be addressed. An investor purchasing shares of oil companies in the secondary market isn’t.
In this world you see unfolding, what role does gold play in a portfolio?
You should own some, for reasons that are well known and understood. Gold does retain its value, it does protect you against potentially unknown consequences of monetary debasement.
Should we look at Bitcoin the same way we used to look at gold?
I am structurally quite bullish on crypto currencies, but they have had one hell of a run, and they are just less attractive now than they were a few months ago. The thing is, we don’t know how to value Bitcoin, so we have no idea whether at $50’000 it’s overvalued or not.
And if you had to choose between gold and Bitcoin?
I don’t see them as mutually exclusive, but complementary. Gold doesn’t have the upside that Bitcoin has, but it doesn’t have the downside either. Many investors still can’t touch Bitcoin because it could get them fired if Bitcoin drops by 50% in a month – which it does, and which it will. But as Bitcoin becomes more institutionalized and more accepted, which is absolutely happening, its ownership gets more dispersed, and volatility will come down. So the narrative that seems quite reasonable to me is whatever your gold allocation is, have some of that in crypto.