Forget about Gold, it's time for real assets

What happened

Following the invasion of Ukraine by Russia, the alliance of the West is reborn. They imposed strong financial sanctions against Russia and its financial and commodity industry such as the seizure of Bank of Russia’s FX reserves or the SWIFT ban. However, as Russia is the largest commodity producer, unintended consequences are happening and can eventually hurt significantly the western economies.

Impact on our Investment Case

Financialization of the commodity market

Contrary to the ‘70s, when the commodity market was over-the-counter and controlled by a few (spot oil market was created by Marc Rich in the ‘80s), nowadays, the notional amount involved in commodity trading is simply unknown. The network is much bigger, and the market and its derivatives are more opaque than the housing market 15 years ago. This murky network leads to potential unintended consequences when the commodities’ flow is disrupted. According to some, derivatives are “financial weapons of mass destruction”. Moreover, the freezing of assets of one of the major counterparties eventually intensifies the crisis, as the Bank of Russia’s liabilities are the assets of someone else.

The resulting disruption can be observed through the fact that virtually all commodities are trending in the same direction and with short squeezes popping up everywhere. The culprit is always the same: cash shortage. And it can also be observed through classical measures such as the FRA-OIS and the TED spread or cross-currencies basis. 

The root of every crisis

There is a common pattern to every crisis: excessive leverage, a drop in collateral value, no liquidity, and/or scarce funding. Stresses in one of these parameters directly impact the market, spreads widen and a crisis erupts. Eventually, an ultimate savior comes to relieve the market by closing the spreads.

Currently, stresses are observed in funding and commodity (collateral) values. An obvious example of the latter is the spread between Ural and Brent oil.

Given the political nature of Western sanctions, the most likely candidate to play the savior and solve this crisis is China and its central bank. China is the only one that could buy Russian oil (at a very cheap price) and basically close the spread. By doing so, China would fund its growth at a better price than the West, and increase the reserve status of the Yuan, a trend we started discussing last year already. 

Potential Stagflation

Disruptions lead to imbalances in the supply and demand equilibrium. Currently, the disruption is causing a supply shortage of commodities, driving prices higher. Commodities and energy are the main input for economic growth. Thus, less available input translates into less growth. Therefore, growth expectations, which started to decline months ago, are accelerating downward as the energy shortage materializes. Moreover, the latter also exacerbates inflation expectations to the upside. For example, the 10y breakeven rates are trading at 2.90%, i.e., 20bps above its all-time-high.

This combination of low-to-no growth and high inflation is what investors fear the most: stagflation. Also the general public is getting concerned as the issue is becoming more and more prominent: search for “stagflation” skyrocketed last week, as shown by Google Trends. 

Adding to the mix a flat curve and the fact that the central banks did not even start their hiking cycle, the probability of a recession in the next two years is increasing. In fact, the Eurodollar market already prices a rate cut by the end of next year.

Differences and similarities with the ‘70s

While many draw similarities with the ‘70s, there are also key differences. Regarding similarities, like the ‘70s, inflation in the U.S. is relatively high and oil prices had already doubled before the current crisis-implied spike. Moreover, it seems that some OPEC members are not inclined to increase supply.

However, an important difference is the significant financialization of the commodity market. Indeed, financial products and derivatives are eventually linking all commodities together which makes subject to the market stresses via for example the source of funding. Thus, the diversification benefits of the commodities in the context of portfolio allocation are reduced.

Besides, the demographic is working differently: today, working-age population growth is trending down, and automation increasing, leading more toward deflation. In the '70s demand-driven inflation was the result of the arrival of baby boomers in the working force. Finally, the energy intensity improved significantly for the past 50 years, marginally reducing the need for energy to generate growth. 

Portfolio Allocation

To hedge the risk of stagflation, investors tend to own real assets, such as gold, real estate, and commodities. These are the asset classes that, in the past, performed the best during the stagflation of a jubilee ago. However, times have changed and these assets may not provide the same returns.

Regarding Gold, after the seizure of its FX Reserve, the Bank of Russia's main asset is gold, representing $150bn. They still have full control over it,  but might be forced to sell.  Even if some U.S. senators would like to sanction entities transacting gold with Russia, there will still be buyers but at a discount.

As for real estate, given the low yields of the past few years, as well as the various easy monetary and fiscal policies, real estate is at its all-time high and the year-over-year change is also at an all-time high. Moreover, the West is entering a new cycle of tighter monetary conditions which is a headwind to the housing market.

Concerning commodities, this crisis is literally about this asset class and investors would need to be extremely skilled to be able to hedge this crisis using commodities.

As an emerging asset class, whose role in facilitating transactions is likely to surge among the hurdles created by the current economic sanctions, the crypto-currencies market is likely to attract attention, but investors should understand the risks involved. 

Finally, equities (notably high-quality stocks) remain the real asset of choice that can eventually help the investor navigate this challenging time.

Alternative Energies

This crisis is a wake-up call for the West and the Europeans in particular. They realized how dependent on others they are regarding both military defense and energy sources. Russian gas accounts for more than 40% of Europe’s gas consumption. The need for independence has become an issue of national security and implies the need to shift towards non-fossil energy. This makes the European renewable energy sector particularly appealing. The latter will likely be boosted by governments incentives as this crisis is forcing them to accelerate the shift.

Our Takeaway

As written in our previous article and confirmed by current events, we remain convinced that China will be the ultimate winner of this war. The current slowing of growth in the Western world combined with commodity-related supply-shock inflation raises the concern of stagflation. Contrary to common belief, gold may not protect portfolios given the likely selling pressure from Russia, real estate is in danger given its high price and the beginning of the hiking cycle, and commodities are precisely the asset at the core of the current crisis.

Thus, having a portfolio of equities, overweighted in Chinese equities, cryptocurrencies, and renewable energy companies seems the most appealing of options.