|  | Inflation Protection Model Portfolio |
| Monthly Portfolio Review: September 2024Publication date: October 2, 2024 |
| | | Current portfolio holdings |
|  | | FOR SUBSCRIBER USE ONLY. DO NOT FORWARD OR SHARE. |
| | | The Inflation Protection portfolio generated a total return of 2.2% in September, edging out the S&P 500 Index, which returned 2.1%. Performance was led by Freeport-McMoRan (FCX), which benefited from the effect of China stimulus on copper prices and returned 13%. Floor & Decor (FND) also did well as the Fed’s pivot on interest rates should spur home remodeling activity. FND shares advanced 10%. The portfolio was able to outperform the index despite much greater relative exposure to oil and gas stocks, which lost ground in September as a result of falling oil prices. Despite recent moderation in the growth rate of consumer prices, long-term structural inflation drivers remain intact. For the benefit of Model Portfolio subscribers, we elaborate on our recent discussion of gold and crypto as portfolio diversifiers with some specific investment strategies.
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| | | The Inflation Protection portfolio delivered a total return of 2.2% in September and slightly outperformed the S&P 500 Index, which returned 2.1%. For the three months ending September 30, the portfolio returned 4.4%, versus 5.9% for the S&P 500 Index.
Portfolio performance was led by Freeport-McMoRan (FCX), which returned 13%, Floor & Decor (FND), which returned 10%, and Brown-Forman (BF), which returned 8%. The largest portfolio detractors were Diamondback Energy (FANG), down 12%, and Permian Resources (PR), down 4%. |
| After an erratic August, volatility settled down. Stocks generally showed positive momentum in September, thanks in no small part to the Fed’s decision to cut the Fed funds rate by 50 basis points on September 18.
The market has seemed to embrace the overall narrative of “soft landing” that Fed Chair Jerome Powell essentially articulated at the FOMC meeting. Heading into the meeting, the market was ambivalent about whether the Fed would cut 25 or 50 basis points. Investors were also ambivalent about which scenario would be better for stocks.
The fact that the Fed went for the 50 basis point rate cut is notable in that the Fed usually only deploys a “supersized” rate cut in relatively dire circumstances. Over the past 25 years, the only times the Fed cut 50 basis points were in three distinctly worrisome scenarios: after the Covid pandemic hit, as the Global Financial Crisis set in, and following the dotcom burst.
A steep rate cut naturally raises the question of just how weak the outlook for economic growth is, after more than two years of restrictive monetary policy and a series of disappointing jobs reports and downward revisions.
Powell was emphatic in the meeting that the rate cut decision was merely to protect what is still a strong labor market, rather than signaling a major deterioration.
As Powell explained, the rate cuts come in the context of short-term rates that are still well above neutral levels, suggesting the Fed has substantial room to bring rates down. Meanwhile, recent Consumer Price Index (CPI) readings are now coming in between 2% and 3% and seemingly approaching 2% target levels.
Stocks, and risk assets generally, tend to respond positively to any shift in the direction of greater liquidity, which is what lower interest rates provide. The more money sloshing around the system, the more spending and investment can take place. From a valuation perspective, falling rates also increase the discounted value of cash flow streams, boosting asset prices.
The key risk to markets is that investors interpret aggressive monetary stimulus as a sign that the economy is falling apart. Powell seems to have succeeded in comforting markets that this is not the case.
Long-term interest rates were generally flat over the course of the month, notwithstanding the sharp cut in overnight lending rates. The yield on the 10-year Treasury was more or less stable around 3.75%.
If bond investors perceived recession risk, we would have likely seen lower long-term bond yields. Bond investors therefore also appear to be embracing the soft landing story.
Looking at September from a sector perspective, much of the movement was idiosyncratic—in other words, driven by the performance of specific stocks—rather than signaling broader trends.
Consumer Discretionary stocks led the way, after having lagged somewhat in prior months due to recession-related concerns. It is worth mentioning that Magnificent Seven constituents Amazon (AMZN) and Tesla (TSLA) are classified within Consumer Discretionary and combined represent nearly 40% of the sector’s market capitalization.
TSLA shares performed particularly well in September, rising 22%. This drove most of the outperformance for the Consumer Discretionary sector. |
|  | Energy was the worst performing sector in September. Oil prices have come down, with softening U.S. employment data and weak economic growth in China. Along with signs of softer demand, in recent weeks, Saudi Arabia has indicated it intends to expand production, sending oil prices to their lowest levels this year. |
|  | On September 24, less than a week after U.S. rate cuts were implemented, China announced significant monetary stimulus measures itself. This has led to a rapid rise in the Chinese stock market, which has performed abysmally since 2021.
The MSCI China ETF (MCHI) returned 22% in September, although Chinese stocks still remain way below their highest levels of three years ago. A number of U.S. stocks with significant exposure to China, such as industrial metals companies, also benefited from the news of aggressive stimulus. |
|  | While we have seen no official reports that speak to direct coordination, the timing of Saudi Arabian production increases and Chinese stimulus measures seems more than coincidental.
China has become Saudi Arabia’s most important customer and one of its major investors. And now, in part through Saudi involvement with the BRICS association, the Saudis are increasingly a political ally of China.
On September 11, Saudi Arabia’s massive state-owned energy company Aramco announced a major commercial partnership with China, following a visit to the Kingdom by China’s second highest ranking official. |
| | Aramco, one of the world’s leading integrated energy and chemicals companies, has announced agreements with key Chinese partners during a visit to the Kingdom of Saudi Arabia by a senior delegation led by Chinese Premier Li Qiang. The agreements reinforce Aramco’s ongoing contribution to China’s long-term energy security and development, support China’s participation in Saudi Arabia’s economic growth, and foster collaboration in new technology development. - Aramco press release (9/11/2024) |
| | The Saudis ultimately want a reinvigorated Chinese economy that consumes more oil. They would potentially have an incentive to help China embark on a stimulus program by helping them avoid inflationary pressure from higher oil prices.
Whatever is motivating Saudi production increases, if oil prices stay subdued, the effect will be disinflationary. This will allow both the Fed and the Bank of China to continue to pursue looser monetary policies.
The S&P 500 has returned 22% this year through September 30. It is an impressive result, but many of the conditions for strong stock market performance are in place—falling interest rates in the U.S. and around the world and a massive technology infrastructure buildout for AI that is supporting earnings growth across the economy.
While the U.S. economy may be more fragile than Jerome Powell is telling us, investors in businesses that can tolerate some macroeconomic softness are well-positioned to benefit from the falling rate environment and other positive trends.
Revenge of the homeowner
Home equity data may provide some reassurance that our consumer-driven economy is not teetering on collapse. The post-pandemic inflation wave has been extremely challenging for much of the American population, but homeowners have arguably made out quite well. |
|  | The inflationary injection of trillions of dollars into the economy, on both the fiscal and monetary sides, has hurt workers with minimal savings but has benefited leveraged asset-owners, such as the typical American homeowner with a mortgage.
Household home equity has exploded some 70% over the last four years and now stands at $35 trillion (more or less the same figure as U.S. federal debt, coincidentally). Remarkably, this is more than a four-fold increase from the post-housing bubble bottom in 2012.
As interest rates come down, homeowners will be able to access this capital appreciation more efficiently, through home equity loans and other forms of leverage.
Inflation outlook
While the Consumer Price Index (CPI) has been decelerating and dynamics in the oil market are disinflationary, long-term structural drivers of inflation remain in place. As we recently discussed in the 76report, the inflation that the U.S. experienced in the 1970s and 1980s came in three separate waves, with pauses followed by even higher peaks.
Job growth is now starting to take precedence over price stability at the Federal Reserve, while the Bank of China is also now shifting in the direction of money printing, adding to global liquidity. Meanwhile, U.S. household demand is backstopped by residential property values that may only advance further as interest rates come down.
We are in a period of short-term inflation relief, but inflationary pressures across the economy remain intact, which should accrue to the benefit of inflation-sensitive stocks. |
| | | Performance in the Inflation Protection portfolio was led by Freeport-McMoRan (FCX), which returned 13%, Floor & Decor (FND), which returned 10%, and Brown-Forman (BF), which returned 8%. The worst performers in the portfolio in September were Diamondback Energy (FANG), down 12%, and Permian Resources (PR), down 4%.
FCX shares advanced with positive momentum in copper prices, which rose 6% in September, following the stimulus announcements coming out of China. As we have discussed, copper mining stocks like FCX are attractive because of the long-term demand (and constrained supply) story around copper related to the electrification trend.
China construction remains a major source of demand for copper, however, and drives volatility in the copper price. Copper prices peaked this year close to $11,000 per ton, but then fell close to $8,500 per ton in early August as investors grew wary of global growth prospects. As of the end of September, copper prices are once again approaching $10,000 per ton.
The government of China is clearly committed to doing what it can to reinvigorate its faltering real estate sector, which should help support copper prices in the short to medium term.
As we have observed, FND is a relatively volatile holding within the portfolio but an attractive, early-stage, long-term retail play with the potential to dominate a niche category.
The current high interest rate environment has pressured home remodeling activity for a number of reasons. Households often use Home Equity Lines of Credit (HELOCs) to fund remodeling projects. HELOCs are typically tied to the prime rate, which is directly tied to the Fed funds rate. The high Fed funds rate has made it especially costly for homeowners to access these credit lines.
Homeowners also engage in home remodeling when they prepare a house for sale or move into a new home. High mortgages rates have frozen residential real estate activity somewhat, as current homeowners are reluctant to abandon potentially low-rate mortgages and new homeowners cannot afford high mortgage payments.
FND is likely to experience a consumer demand tailwind as the Fed funds rate comes down and remodeling activity picks up. As noted above, U.S. households have 70% more home equity than they did just four years ago. That is a lot of borrowing power!
BF is a leader in the spirits sector, with especially strong positioning in the whiskey category, but has struggled somewhat this year as post-pandemic liquor inventories remain high. Recent strength points to gradual burn-off of these inventories as well as renewed demand in international markets, which China stimulus should help as well.
As noted above, oil prices have declined substantially. This has put pressure on portfolio holdings FANG and PR.
Shares of FANG were also affected by some selling pressure related to its recent acquisition of a family-controlled oil and gas company, Endeavor Energy Resources. Although we regard the acquisition as positive, a secondary offering led to placement of the shares in a difficult environment for oil and gas stocks.
While lower oil prices have affected shares of PR as well, we continue to believe there is a high medium-term probability it gets acquired given the quality of its asset base and the disparity in valuation metrics with larger players.
PR has also modified its shareholder return policy, raising its base dividend, now over 4%, while continuing to focus on share repurchases, which can be quite value-added in periods of share price weakness.
Given that the Inflation Protection has much higher oil and gas exposure than the S&P 500 Index (15% versus less than 3%), we are pleased the portfolio was able to outperform the index in a month when oil prices faced a notable setback.
Our gold-related holdings were generally flat this month, although gold as a commodity performed well. The price of gold in dollar terms advanced approximately 5% in September, assisted by Fed rate cuts. Chinese stimulus was also helpful given the relevance of Chinese consumer demand to the gold price.
Physical gold also tends to outperform gold-related equities in periods of geopolitical instability. Turbulence in the Middle East likely contributed to demand for gold in September.
The precious metal streaming plays we hold in the Inflation Protection portfolio—Franco-Nevada (FNV), Royal Gold (RGLD), and Wheaton Precious Metals (WPM)—may underperform or outperform physical gold in any time frame, due to macro or company-specific factors. Over time, however, they have tended to outperform gold as essentially leveraged plays on gold price appreciation. |
|  | When it comes to gold exposure, investors have a diversity of investment options, from physical gold (whether owned directly or through ETFs) to gold-related equities.
Physical gold is especially useful as a tool for portfolio management, especially as a reserve of buying power during a market crisis. Gold-related equities on the other hand have the potential to deliver more long-term upside with rising gold prices.
Just as diversification makes sense across a broader investment portfolio, diversification within one’s gold allocation also makes sense. |
| | Dollar-Proofing Your Portfolio
As a continuation of our recent 76report on using gold and cryptocurrency as portfolio diversifiers, we wanted to offer some specific ideas for Model Portfolio subscribers interested in gaining exposure to these assets through ETFs.
Many investors choose to own physical gold either directly or through a third party, just as many crypto investors prefer to own Bitcoin and other digital currencies with a “cold wallet” or through a custodian like Coinbase.
For those less focused on privacy or direct ownership, there are numerous ETF options available that are sponsored by reputable asset managers. Gold ETFs have been available for decades, while cryptocurrency ETFs, specifically Bitcoin and Ethereum, were just launched this year.
Some of the most well-known gold ETFs include SPDR Gold Shares (GLD), iShares Gold Trust (IAU) and VanEck Merk Gold (OUNZ). These ETFs vary somewhat in the fees they charge as well as the mechanisms by which gold exposure is obtained, where and how the gold is stored, and other logistical details.
We encourage investors to read the fund literature associated with these different instruments carefully. We would note, however, that performance differentiation among the gold ETFs has historically been quite limited.
The chart below shows the three above-mentioned ETFs in relation to the spot price of gold over the past ten years. The key take-away is that all of the ETFs essentially serve the function they intend to serve (tracking the price of gold), such that there is no material performance difference among them. (Spot gold marginally exceeds the ETF performance as no management fees are considered.) |
|  | With the recent launch of several Bitcoin and Ethereum ETFs by well-known asset managers, we would expect to see similarly comparable long-term performance in terms of closely tracking the underlying asset class.
As we have researched crypto ETFs, we became aware that Grayscale, a pioneer in the crypto space, sponsors two ETFs that offer investors exposure to Bitcoin as well as two ETFs that offer investors exposure to Ethereum.
Before the SEC approved Bitcoin and Ethereum ETFs, Grayscale originally provided access to these digital assets through a trust structure, similar to a closed-end fund. We discussed the history of Graystone Bitcoin Trust (GBTC) here.
These original vehicles have since been converted to ETFs but retain significantly higher fees relatives to new ETFs that have been created by the manager. Based on our research, Grayscale’s “Mini Trusts” are essentially the same as the original trusts but have substantially lower fees.
(Among reasons that an investor would still use the original higher fee vehicles is that they are sitting on high unrealized capital gains and do not want to sell, or compliance issues require an institutional investor, for example, to be invested with a fund that has a long track record.)
The new lower fee ETFs managed by Grayscale are the Grayscale Bitcoin Mini Trust (BTC) and the Grayscale Ethereum Mini Trust (ETH).
Other major sponsors of Bitcoin and Ethereum ETFs include Blackrock and Fidelity. Blackrock offers the iShares Bitcoin Trust ETF (IBIT) and the iShares Ethereum Trust (ETHA), while Fidelity offers the Fidelity Wise Origin Bitcoin Fund (FBTC) and the Fidelity Ethereum Fund (FETH).
A potentially interesting distinction between the Grayscale and Blackrock products versus the Fidelity products is that Grayscale and Blackrock use Coinbase as the custodian for the funds’ crypto holdings, while Fidelity self-custodies. Self-custody means a business unit within Fidelity is responsible for providing the cold storage of the digital assets held by the funds.
Potential tax strategies
While we do not offer individual investment or tax advice, just general research and information, our understanding is that the IRS has never issued specific guidance as to whether an ETF that tracks a certain underlying index is “substantially identical” to another ETF that tracks the same or a similar index.
The question is relevant in that U.S. investors (with taxable accounts) run afoul of the “wash sale” rule when they realize capital losses in a security but then repurchase the same or a “substantially identical” security within 30 days. The wash sale rule disallows the realization of capital losses for tax purposes under those circumstances.
If an investor were to realize losses in a certain gold ETF, and then immediately purchase a different gold ETF, for example, our understanding is that such a transaction would not automatically trigger a wash sale adjustment by the brokerage firm in which the account was held. By contrast, if an account holder were to sell and then repurchase the same exact security, whether it is an ETF or a stock, the system would automatically flag it as a wash sale.
The fungibility of ETFs for gold and crypto therefore creates the opportunity for investors to realize potential capital losses while immediately being able to transfer their capital into another similar (but not substantially identical) security that offers comparable exposure.
The ability to generate capital losses (which can be carried forward to future years to the extent an investor does not have current year gains to offset) is especially relevant for high volatility investments, like crypto. High volatility investments, by definition, move up and down a lot and therefore have a higher probability of producing large, but hopefully temporary, losses.
Here is a step-by-step hypothetical example of how an investor in a highly volatile Crypto ETF could make “lemons out of lemonade” if the investment were to trade down:
(1) Buy hypothetical Crypto ETF A.
(2) If Crypto ETF A trades down significantly, say 20%, sell Crypto ETF A.
(3) Immediately use the proceeds from the sale of Crypto ETF A to buy similar (but not substantially identical) Crypto ETF B.
(4) Wait 30 days to move the capital back to Crypto ETF A or simply stay invested in Crypto ETF B. (If there are additional losses after 30 days, the investor could flip back to Crypto ETF A, or even purchase Crypto ETF C.)
The general idea here is to derive some benefit from the high volatility of crypto investments that are made in the context of a long-term buy and hold strategy. Gains could be deferred for many years. Meanwhile, any (hopefully temporary) capital losses could be realized sooner, while the investor maintains his or her exposure to the asset class. These realized losses can then be used to reduce an investor’s overall capital gains tax liability.
These concepts can of course be applied more broadly. Again, we offer these ideas and strategies as food for thought, not investment or tax advice, and encourage readers to do their own research and/or consult with tax experts on these matters. |
| | |  | | |  | | |  | | | |  |  | | |  |  | | |  |  | | |  |  | | |  |  | | |  |  | | |  |  | | Diamondback Energy (FANG) |
|  |  | | Floor & Decor Holdings (FND) |
|  |  | | |  |  | | |  |  | | WESCO International (WCC) |
|  |  | | Wheaton Precious Metals (WPM) |
|  |  | | The 76research Inflation Protection Model Portfolio emphasizes business models that are expected to perform well on a relative basis in periods of elevated inflation. Holdings are typically selected from industries based on supply constrained real assets, including commodity and energy businesses, or companies that otherwise demonstrate superior pricing power. Drawing from an investable universe of expected inflation beneficiaries, specific holdings are chosen based on valuation and general business quality, growth and risk considerations. |
| | FOR SUBSCRIBER USE ONLY. DO NOT FORWARD OR SHARE. |
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