One Observer’s Take on the Fed, Tightening and the Markets

Source: Adrian Day   01/19/2022

Adrian Day of Global Analyst takes a look at the macro picture in light of Fed Chairman Jerome Powell’s more hawkish comments last week and also reviews recent developments at some companies on his list.

Last week, in his re-appointment testimony in Congress, Federal Reserve Chairman Jerome Powell tried to act tough, saying the Fed “could raise rates more over time,” and emphasized that the Fed felt people’s pain on inflation. He said that the Fed would ensure inflation “does not become entrenched”…was prepared to raise rates more…would “remain vigilant”…and would “use our tools.”

This of course is the same Fed chairman that only a few months ago was insisting that inflation was only “transitory,” all the fault of supply shocks. Inflation was a good thing, the Fed had said for some time, actually wanting to increase inflation, and saying that the Fed would aim for inflation above its 2% target for a while to offset the period when inflation was below 2%. Besides, inflation mainly affected the wealthy, not ordinary people, they said.

Like many others, I disagreed with all this at that time. Now Powell, and other fed officials, have said inflation is more persistent, it is not just supply shocks, and it does affect ordinary people.

Who can sound the most hawkish?

Different Fed spokesmen, joined by the large banks, have each been trying to outdo each other in their predictions for more tightening. President of the Atlanta Fed Raphael Bostic said the Fed “could easily pull $1.5 trillion of excess liquidity.” It was intended to sound like a lot. But given that the Fed’s $9 trillion balance sheet was less than $4 trillion only two years ago, it really is not a lot at all; it would be less than one third of the increase (and we are not even going back to the increase since 2008). He went on to add that the Fed could then watch the market reaction to decide on further reductions. Mmm…I didn’t realize that propping up the stock market was one of the Fed’s mandates.

Goldman is now calling for four interest rate hikes this year and an earlier than scheduled balance sheet reduction (a trial balloon leaked to Goldman?). Raise you, says JP Morgan’s Jamie Dimon. “I would be surprised if there are just four interest rate hikes this year.”

Dimon says that this year is going have the best growth ever, since after the Great Depression. He also noted that consumer loan growth—something presumably he actually knows about—would take up to nine months to return to normal. In the best economy in 100 years? Mmm…

All this is bluff. Let’s not forget that even under the most aggressive “tightening” that’s been bandied around, the Fed’s balance sheet will still be higher at year end than it was last year and real interest rates will still be negative, and significantly so.

The market no longer believes the narrative

For months, much to my frustration (and that of others), the market seemed to believe the Fed’s narrative. The response this week to the “new” Powell? The market laughed at him. After Powell’s tough-guy act, stocks are up, gold is up, bond yields are down, and the dollar is down, the precise opposite of what one would expect if the Fed truly were to act tough.

We have noted before that gold has fallen for months ahead of any taper or rate cut, but risen for the period after the Fed actually started. This has been the case all the way back to the early 1990s. This is because the Fed can sound tough all it wants but when it actually starts to act, it’s too little too late, and the market can clearly see that. In this cycle, the Fed is massively behind the curve on inflation.

The same phenomenon holds for the dollar. The below graph, courtesy of analyst Larry McDonald, is stunning.

The market, after seemingly believing the Fed’s narrative for the past six months, has finally called its bluff. However, if the Fed tries to move more meaningfully to tackle inflation—it still won’t get ahead of it, the way Paul Volker did in 1980—the stock market will have another hissy fit and like most analysts, I believe the Fed will back down. That would be the most bullish signal yet for gold.

Nestle, with enhanced war-chest, to buy back shares aggressively

Nestle SA (NESN:VX; NSRGY:OTC) (NESN, Switzerland, 120.84) sold an additional 22 million shares in L’Oreal back to the company, which cancelled the shares. Nestle raised 8.9 billion euros, reducing its ownership interest by over 3 percentage points to just over 20%. The move was not a surprise and had been mooted for some time. Following this, Nestle said it was introducing a new buyback program, with the plan of repurchasing Sfr 20 billion of its shares by 2024. Last year, under a former plan, it acquired Sfr 12.7 bullion in shares.

The developments sent Nestle shares to record highs early in the new year, just shy of Sfr 130, before giving back most of the gain. We are holding, given highest valuations in more than a decade.

High yields continue at BDCs

Ares Capital Corp. (ARCC:NASDAQ) (ARCC, Nasdaq, 21.44) reported third quarter earnings above its estimate and the prior year. The strong revenue was largely driven by fees as originations continued to be strong. Book value increased and credit stats improved. Last week, Ares announced a $10 billion offering of its shares at $21.40; the shares were at a high of $22.30 when the pricing was set. Ares has now reported its fourth-quarter portfolio activity, which was very strong. It will report financials in mid-February. Ares is a hold, and, with a yield of 7.65%, even a buy for income-oriented investors who do not own.

Gladstone Investment Corp. (GAIN: NASDAQ) (GAIN, Nasdaq, 16.23) announced it would do another extra distribution of 12 cents in February (with record date of 4th). This follows another extra distribution in December. After increasing the regular monthly distribution from 7 cents to 7.5 cents in October, the monthly distribution will remain the same for the next few months.

The supplemental distributions typically come from new capital gains, while the monthly distribution is from interest on loans, as well as origination or closing fees. Because the extra payments are not on a regular schedule and can fluctuate significantl—the previous payment was just 3 cents—the combined yield must carry an asterisk. But if the February amount were paid twice during the year, then the combined yield would be over 7%.

Most gold miners see slight misses

Osisko Gold Royalties Ltd. (OR:TSX; OR:NYSE) (OR.NY, 11.66) reported on its fourth-quarter sales, saying it earned just under 20,000 of gold equivalent ounces (GEOs), for a total of about 80,000 during the year, in line with earlier guidance, but below analyst expectations on a shortfall from one mine, Eagle. (This was due to a shortage of some equipment, since resolved.) The numbers include GEOs from the Renard diamond stream, which had been excluded earlier. This led to record quarterly revenues of over C$50 million. Buy.

Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX) (RGLD, Nasdaq, 99.53) announced preliminary streaming numbers for the December quarter, saying it had sold about 61,700 GEOs with another 26,000 GEOs in inventory. This is a decline in sales from the previous quarter (64,300 GEOs) with a similar volume in inventory at quarter end. Royal is transitioning from a June fiscal end to a December fiscal end. Buy.

Agnico Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) (AEM.NY, 51.41) reported just before Christmas that it would reduce mining activity at its Nunavut operations following an increase in Covid cases, resulting in minimal production until an expected resumption “early 2022.” Buy.

Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE) (AUY.NY, 4.18) as expected, had a good end to the year. Its fourth-quarter operating results, with production of 281,388 GEOs exceeded its guidance, while the full-year production of 1.01 million GEO also exceeded guidance. Hold.

Tax hikes at major asset

Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) (FNV.NY, 130.04) received news that the Panamanian government intends significantly increasing taxes on Cobre Panama, which is Franco’s largest single streaming asset. The ultimatum would impose a 16% new smelter royalty as well as void the tax holiday granted the operating company. The terms, as stated, are quite onerous, and, given the very short deadline for a reply (essentially over the weekend), suggest a breakdown in discussions.

The final terms still have to be determined, and Franco’s stream would not be directly affected. But of course exorbitant taxes on an operation affect the economics of the operation, and can make expansions less likely, ultimately affecting the stream. Franco is a buy for those who do not own it.

Newmont steps up its virtue signaling

Newmont Corp. (NEM:NYSE) (NEM.NY, 61.22) sold $1 billion of bonds linked to its performance on various ESG measures. If the company doesn’t cut emissions or boost the number of women at the top by various metrics, then the bonds will pay a higher interest rate than the nominal 2.6%. This is calculated to gain accolades among the ESG investing crowd, but it gives Newmont an incentive, among other things, to promote women over more qualified candidates. Or is this an admission they were not promoting qualified women before? More peculiarly, it means investors receive higher interest if the company fails to cut emissions, a perverse reward for ESG-investors.

Exploration companies continue to advance projects

Midland Exploration Inc. (MD:TSX.V) (MD, Toronto, 0.50) said its partnership with SOQUEN in the Labrador Trough had discovered a new gold-bearing boulder, while other results in the Trough were said to be encouraging. The results confirm the potential of the area, and the alliance had acquired new claims based on recent results. Two new exploration campaigns are planned for the summer.

Separately, the company completed another equity issue of “flow-through shares” at above-market prices. Midland’s share count has steadily increased since 2015 when it stood to 53.3 million shares to the post-financing 75.5 million. We are holding.

Azucar Minerals Ltd. (AMZ:TSX.V; AXDDF:OTXQX) (AMZ, To., 0.085) reported it had identified a new porphyry target at its large El Cobre project. The shares significantly undervalue the property, though fully exploring it will take time. Hold.

Almadex Minerals Ltd. (DEX:TSX.V) (DEX, To., 0.30) announced a new drill program underway at one of its exploration properties, San Pedro in Jalisco, Mexico. This is one of many exploration projects in its portfolio, which essentially come “free” after valuing the cash, shares, royalties and other assets it holds. Buy for patient investors.

Reservoir Capital (REO, Toronto, halted) was removed from the Ontario Securities Commission delinquent filer list just before Christmas, with regard to its prior year’s financial reports. It still needs to file 2021 quarterly and full-year reports, but it marks progress towards getting the shares trading again. Hold.

Originally published on Jan. 16, 2021.

Adrian Day, London-born and a graduate of the London School of Economics, is editor of Adrian Day’s Global Analyst. His latest book is “Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks.”

Disclosures:
1) Adrian Day: I, or members of my immediate household or family, own securities of the following companies mentioned in this article: Nestle, Ares, Gladstone, Royal Gold, Franco-Nevada and Midland Exploration. I personally am, or members of my immediate household or family are, paid by the following companies mentioned in this article: None. My company has a financial relationship with the following companies mentioned in this article: None. Funds controlled by Adrian Day Asset Management hold shares of the following companies mentioned in this article: All. I determined which companies would be included in this article based on my research and understanding of the sector.

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