Inflation investing

Investments to watch as inflation climbs and rates rise

Major stock markets have been enjoying something of a rebound lately. And the rally in equities has been matched by an equally strong rebound in bonds, at least at the long-dated end of the market.

July’s annual U.S. inflation rate was 8.6%, down from June’s 9.1%. Stock markets celebrated with a rally, as traders felt the Fed could achieve a “soft landing” – controlling inflation sufficiently without causing a recession. With unemployment still at 50-year lows (less than 4% in the U.S. and U.K., and 5% in Canada), there would appear to be room for some tightening without necessarily plunging the economy into a deep recession.

But the Fed and other central banks don’t have a great track record of achieving a soft landing. Given wrong their forecasts were on inflation remaining “transitory” last year, it’s difficult to see why investors would have such confidence in a benign outcome.

The best forecaster of recessions is an inverted yield curve. This occurs when short-term interest rates are higher than long-term rates, usually taken as the relationship between 2-year bonds and 10-year bonds. The curve has inverted steeply in the last couple of months, meaning that investors can get a higher yield in 2-year bonds with little exposure to rising interest rates as duration is very short.

Why the inversion? Bond traders thinking seems to be guided by the Fed’s past actions in always backing down and starting to cut rates whenever the economy showed signs of slowing or the stock market dropped.

Rate hikes still to come

This time, however, inflation is so high that central banks can’t realistically back off from raising rates if they wish to retain credibility. With inflation at 8.5%-9%, even interest rates at 3.5% or 4% would mean real interest rates would be -4%. Even if the month-over-month increase in inflation is zero every month from now until the end of the year, as was the case last month, the annual inflation rate would still be 6%. With real estate, which works with a long time lag, comprising over one third of the consumer price index, inflation will still be well above 4% this time next year without any other unpleasant surprises like the invasion of Ukraine.

Investors should therefore keep their bond exposure short, but look at sectors such as financials, which benefit from higher interest rates as their net interest margin widens and the cost of their long-term liabilities is reduced. If there is a recession, these factors should outweigh higher loan losses, especially as unemployment levels, the principal cause of bad debts, are still at very low levels.

The other approach is to look at those sectors that are direct beneficiaries of rising inflation, such as commodity producers, especially given the lack of new supply and supply chain issues that will likely keep prices higher than expected.

Precious metals miners

Lastly, consider precious metals, which are inflation beneficiaries and not highly correlated with either equities or bonds, thus reducing the overall volatility of a portfolio. At present gold and silver miners are selling at extremely cheap prices compared with both the metals themselves and with historical ratios.

For example, consider miner Agnico Eagle Mining (TSX: AEM), a senior Canadian gold mining company and the third-largest gold miner in the world in terms of market capitalization. It has 11 mines in politically stable jurisdictions in Canada, Finland, Australia, and Mexico following its merger with Kirkland Lake Mining in the first quarter of 2022. It also conducts exploration and development in these countries.

Between 2017 and 2021, revenues grew 70%, to $3.8 billion (except per-share numbers, all figures are in U.S. dollars) and operating income doubled to $1.02 billion. Net income rose 120%, to $543 million ($2.22 per share) as Agnico brought two new mines (Amaruq and Meliadine) in Nunavut on line, on time and under budget. In 2021 Agnico produced a record total of 2.03 million ounces of gold at an all in sustaining cost (AISC) of $1.038 per oz. Despite its excellent operational performance, Agnico shares are no higher than they were five years ago when gold was at $1,500 an ounce.

The company also declared a quarterly dividend of $0.40 per share, giving it a yield equivalent to 3.47%, a 6.7% increase over 2021.

The Kirkland Lake deal has added 70% to Agnico’s gold production, and the new evaluation for Detour Lake indicates this mine alone could produce 1 million oz. a year for the next couple of decades, fully half of Agnico’s total production in 2020. Selling no higher than it was five years ago with gold up by one third and its production substantially higher, Agnico is the most attractive major gold miner right now. Before investing, talk to your advisor to ensure the stock fits with your risk tolerance, diversification strategy, and long-term objectives.

Gavin Graham is Chief Strategy Officer of Calgary-based SmartBe Investments. He is a veteran financial analyst, money manager, and a specialist in international investing, with over 35 years’ experience in global investment management.

Notes and Disclaimer

The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.

The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.