Ronald-Peter Stöferle, partner at Liechtenstein-based asset manager Incrementum, explains why he expects a surge in inflation and how investors can protect their portfolio.
Since the early 1980s, the global economy has been characterized by disinflationary trends and falling interest rates. Now the paradigm is shifting; the coming years will be characterized by rising inflation and rising interest rates.
That's the prediction made by Ronnie Stöferle, partner at Liechtenstein-based asset manager Incrementum, in a recently published report titled «The Boy Who Cried Wolf.»
The consequences of this paradigm shift for financial markets would be enormous. «Inflation is still something that no one is currently prepared for. The average investment manager has never had to navigate through markets in a rising inflation environment,» says Stöferle.
He sees a looming exodus from the bond markets and a possibly even more extreme monetary policy. The main beneficiary of a surge in inflation and a bond market exodus would be the commodities sector – and above all gold. In this in-depth conversation with The Market NZZ, Stöferle explains the role of the precious metal in a diversified portfolio and what he thinks of gold mining stocks, silver and Bitcoin.
Mr. Stöferle, warnings of inflation have proven to be a false alarm several times in recent years. Why should this time be different?
You're right, after the 2008 global financial crisis, many voices warned of inflation in the face of unorthodox monetary policy. Back then, most people looked at central banks' balance sheets, but overlooked the fact that broad monetary aggregates stagnated. Central banks at the time were trying to compensate for the collapse in bank credit demand in the aftermath of the crisis. They kind of succeeded at that, but in the process they fueled massive asset price inflation. To that extent, you can say that there was inflation, just not in measured consumer prices. Basically, it's a matter of definition: The Austrian school of economics defines inflation as an expansion of the uncovered money supply. I'd say we've definitely seen that.
But now you expect to see broader inflation, including in consumer prices?
Yes, we are currently living through a paradigm shift.
My main point is that we have seen a shift from a monetary to a fiscal stimulus policy in the context of fighting the Covid-19 pandemic. With the instrument of government loan guarantees, fiscal policy has bypassed central banks in credit creation: If a bank can rely on a government guarantee, it does not hesitate to lend. As a result, in contrast to the period after the financial crisis, broad money supply measured in M2 or M3 is also increasing today. In the U.S., M3 recently expanded by 24% year-on-year. Second, in the U.S., and sooner or later also in the Euro area, a symmetrical inflation target of 2% on average over time now applies. After inflation rates have been far too low in recent years, monetary authorities can now deliberately allow an overshoot. Third, government debt has risen exorbitantly; all taboos have been broken. And we know from history that the higher the government debt, the higher the desire from politicians for inflation. As a final point, I would add that formerly obscure theories like Modern Monetary Theory have now entered the mainstream.
You don't think that the emergency fiscal policy tools will be withdrawn once the crisis is over?
No. It is as Ronald Reagan once said: Nothing lasts longer than a temporary government program.
Broad monetary aggregates may have expanded, but at the same time the velocity of money has collapsed. How is inflation supposed to happen in this kind of environment?
Velocity of circulation has fallen during the lockdown period. But with vaccination programs underway, people will realize over the course of the coming months that the worst of the crisis is over. Businesses and people will normalize their behavior, and with that, velocity of money circulation will recover. The turnaround can already be observed. The combination of a significantly expanded money supply and normalization of velocity can quickly create inflationary pressures. As early as this spring, we will start to see inflationary pressures due to the base effect alone.
The recession has left large idle capacities in the economy. Doesn't this still exert a strong deflationary force?
Yes and no. It's true that there are still strong deflationary forces in the global economy. But I think some of them are starting to subside. Even before the pandemic, for example, globalization skepticism was increasing, and now we've seen how vulnerable global supply chains are. The pressure on companies to bring production closer to their end markets is intensifying. The U.S. and China are in a Cold War 2.0, and that won't change under Joe Biden. Populism is not going away anytime soon. Deflation and inflation are like tectonic plates that are slowly shifting. And I think inflationary forces are gaining the upper hand.
The last forty years or so have been characterized by disinflationary forces in the global economy. Are we at an epochal turning point?
Yes. Mind you, such a paradigm shift does not happen overnight. The foundations have been laid in recent years, with a series of taboo-breaking measures, such as the enormous expansion of government debt and the ever closer interlinking of monetary and fiscal policy. One point I forgot to mention earlier concerns the Dollar: The Dollar tended to strengthen in the decade since the financial crisis, which had a deflationary effect on the global economy. Now, the Dollar is weakening. In the short term, it may be oversold to such an extent that it could recover somewhat in the near future, but from a technical point of view, the Dollar is severely battered. If the U.S. currency now enters a secular weakness, it would have an inflationary effect on the world economy.
What other signs do you see that tell you this paradigm shift is indeed happening?
Inflation-sensitive asset prices indicate that inflation is becoming an issue. I see it in inflation-linked bonds, in precious metals like gold and silver, commodities, including energy, uranium, in agricultural commodities, all the way to inflation-sensitive currencies like the Canadian and the Australian Dollar. When I look at the markets right now, I see almost nothing that's not going up. This reminds me of Ludwig von Mises' description of the crack-up boom. There is a flight into real assets.
How high do you think inflation will rise in the U.S. and Europe?
Annual inflation rates of 4 to 5% would not surprise me.
Prominent economists such as Larry Summers are promoting inflation rates of 4 to 5% as an effective means to reduce government debt. What do you think of that?
I think it is hubris to believe that you can control human interaction, inflation, the economy or financial markets with pinpoint accuracy like an econometric model. Our economic life cannot be regulated like a thermostat.
Suppose we see a surge in inflation in the next year or two: What will happen in financial markets?
First of all, let me tell you that inflation is still something that no one is currently prepared for. The average investment manager is fifty years old, which means they never had to navigate through markets in a rising inflation environment in their career. I see this as a kind of Reverse Volcker Moment: when Paul Volcker took the reins of the Federal Reserve in 1979, no one in the financial community believed he would succeed in beating inflation. Today, by contrast, no one believes that central banks will succeed in generating inflation again.
So what will happen to markets then?
It will be exciting on several levels. First, it will be interesting to see whether and how long Fed officials will resist the pressure to raise interest rates. Inflation is a tax that particularly hits those who cannot protect themselves. To that extent, it will become a political issue. Secondly, there is the question of how high interest rates will rise in bond markets, or whether central banks will intervene and introduce yield curve control to stop the rise in interest rates on government bonds. Currently, $19 trillion worth of bonds worldwide are trading with negative yields. Rising inflation could lead to a huge exodus out of the bond market and into traditional inflation-sensitive assets.
With equity markets as beneficiaries of this exodus?
Possibly. There are studies that show that the comfort zone for equities is an inflation rate between 1 and 3%. Above 3%, however, things start to get critical. In equity markets, you have to carefully distinguish between companies that have pricing power and those that don't. Warren Buffett aptly described this in his 1977 essay «How Inflation Swindles the Equity Investor», which is well worth reading. There are sectors that will benefit and others that will suffer. For the commodities sector, for example, we are very confident. But overall, this will be the biggest question: What will happen to broad equity markets when inflation leaves the comfort zone and rises above 4%? And if both bond and equity markets correct, what will the Fed do? Will it step in to save the day and buy stocks? I don't think that's far-fetched, as it would be the logical continuation of its previous policy. That would then be the phase in which gold would perform fantastically.
So you see gold, not equities, as the main winner in the paradigm shift you describe?
Yes. Of course, equities, as productive assets, belong in every portfolio, but you have to do your homework and look closely at the inflation resistance of companies. My main argument is this: With my inflation scenario and the assumption that central banks limit the rise in interest rates on government bonds, real interest rates will remain negative and probably fall even lower. I really wonder if we will ever see significantly positive real interest rates again in the next 10 to 15 years. Negative real interest rates are the most important driver of the gold price.
In a traditional 60/40 portfolio, bonds serve as a hedge for equities. That would no longer work in an inflationary environment, would it?
No. We've seen a forty-year bull market in bonds, but it's coming to an end. Bonds in a portfolio are like a defense player in football who has performed fantastically for a long time, but is now old and frail. I don't see how government bonds can play that defender position to stabilize a portfolio in the future. That's also part of the paradigm shift.
Can gold play that defender position?
Yes. Gold performed perfectly to expectations in 2020. Like a good defender, it held the line and stabilized the portfolio. During the volatile period in March, gold reacted only briefly to the downside when leveraged investors received a margin call and were liquidated, but in general, gold has behaved exactly as you would want it to. It is supposed to stabilize the portfolio in times of recession, in times of rising inflation, in times of negative real interest rates, in times of crisis. In Dollar terms, gold gained 24% in 2020, 14% in Euros and 13% in Swiss Francs. Gold is not in the portfolio for the short term speculative gain, but as an insurance.
In early August, gold reached an all-time high in Dollar terms, and it has been consolidating since then. What's in store now?
The main reason for the consolidation was that real interest rates in the U.S. went up a bit, from about -1.1% to -0.8%. But as it looks now, the trend has turned again. In the short term, January and February are usually seasonally positive for gold. Since I expect inflation to pick up in spring, I'm very confident for gold in 2021, and for that matter also for silver.
And in the longer term?
As of the end of this decade, with our scenario of higher inflation, more financial repression and yield curve control by central banks, we see gold at around $4800 per ounce, based on our valuation work. A key driver is the fact that demand for physical gold is increasingly moving to Asia. In 1989, China and India were responsible for 10% of demand; in 2019, it was 56%. The momentum is moving towards Asia, and we know that Asia generally emerges as the winner in 2020. It is no coincidence that we have been publishing our «In Gold We Trust» report in Chinese since 2019.
When does an investor actually have to steer clear of gold?
Adversely for the gold price would be, first, if real interest rates rise significantly, and second, if sovereigns get their debt dynamics under control and on a sustainable path. But honestly, I don't see how this dark cloud would suddenly dissipate.
What do you think of gold mining stocks?
Mining stocks contain a lot of additional risks of corporate, geographic, geological and political nature, so you can't equate them with the defender qualities of physical gold. But overall, I really like the sector, and we have used the recent correction to build positions. Now it's time to go on the offensive. During the last bear market from 2011 to 2016, creative destruction took place in the sector. Companies got their costs under control and wrote off unprofitable projects. Now we see that producers have massively increased their margins and pay increasing dividends. Most companies are still calculating conservatively, expecting a gold price of $1300 to $1400 in the long term. Pretty much every measure we look at shows us that gold mining stocks are trading at historically extremely cheap levels. The NYSE Arca Gold BUGS Index is trading at 300 today, the same level it was in 2009 when gold was trading just under $1000. The entire gold mining sector has a market capitalization of a mere $300 billion, less than one-seventh of Apple. The sector is simply too cheap.
What's holding the mining sector back?
On the surface, the issue of sustainability is a problem, as ESG is becoming a must for more and more institutional investors. But there has been a shift in thinking in the industry here, and gold mining companies are now taking the ESG issue very seriously. I have met around 100 mining company management teams at virtual conferences this year, and all have clearly signaled how important ESG standards are to them. In such a capital-intensive business, it would be negligent to risk access to capital markets.
What mining stocks do you like?
You understand that I can't name names. We tend to focus on mid-tier producers as well as development companies that have proven resources in safe jurisdictions with good infrastructure. The sector has not invested in new projects for years, and between 2009 and 2019 capital investment has shrunk by 80%, which is why fewer and fewer new gold reserves are being discovered. We therefore think that there will be a wave of acquisitions in the coming years.
And what's your case for silver?
Relative to gold, silver is historically significantly too cheap. Last spring, we devoted a chapter to silver in the «In Gold We Trust» report for the first time in its 14-year history. At the time, we wrote, «Silver is unpopular, ignored and mildly ridiculed. For the astute contrarian, there has rarely been a better time to invest in silver.» Since then, the price of silver has gained 60%, but it's still cheap. In the wake of the gold correction in recent months, silver has held up fantastically, which was a positive sign. The silver market is very small, so if there is demand there, that can trigger significant price movements. When momentum comes back to the gold market, silver will outperform.
Does that also apply to silver mining companies?
Yes. The sector is tiny and highly volatile, but silver producers are fundamentally better and cheaper than they have been in years.
Currently, silver is trading around $26 per ounce. Where do you see the price in the longer term?
If the gold price develops in the next few years as we forecast, then a silver price of over $100 per ounce is conceivable. We are back in a bull market for gold and silver. This means that corrections have to be bought.
The star performer of the year was neither gold nor silver, but Bitcoin. Shouldn't you go for Bitcoin rather than gold?
I like both, just as I like skiing on the slopes but prefer snowboarding off-piste. At Incrementum, we run the Physical & Digital Gold Fund, whose strategic asset allocation is 75% in physical gold and 25% in digital gold in the form of Bitcoin. Bitcoin is highly volatile, and you have to use this volatility, for example by working with options. 2020 was the year Bitcoin came of age. In the meantime, the necessary infrastructure is there, there are futures and options, none of which existed in 2017. Accordingly, well-known investors have also acquired a taste for it. Bitcoin is a tiny market, its market capitalization is barely $400 billion, compared to more than $10 trillion for gold. Of course, gold has 5000 years of history, has survived every war, every currency reform, every political system, so it has a very different risk profile than a technology that has only been around for a little over 10 years. But basically, for me, Bitcoin is just like gold an asset that cannot be inflated arbitrarily. Both should be included in a diversified portfolio.