First Eagle Investment Management’s market overview for the fourth quarter ended December 2020, discussing gold as a potential hedge.
Q4 2020 hedge fund letters, conferences and more
Key Takeaways
- Though 2020 was a generationally poor period for value indexes relative to growth, hopes that the worst of the Covid-19 recession was behind us helped fuel a fourth quarter rebound in the mature, physical components of the economy most directly impacted by pandemic lockdowns.
- While the massive monetary policy response to the onset of Covid-19 appears to have cushioned the pandemic’s economic impact, it did so at the expense of growing monetary, fiscal and trade imbalances. The ongoing illusion of macro stability serves as a headwind to longer-term productivity and suggests potentially lower real returns for markets in general.
- At First Eagle, we orient our true north around the potential creation of resilient wealth in a complex world. The quality and diversity of our stock holdings, complemented in many of our portfolios by gold as a potential hedge, gives us conviction within an unpredictable and unprecedented landscape.
Views expressed are as of January 7, 2021.
Portfolios Complimented By Gold As A Potential Hedge
Generally strong returns across financial markets in the fourth quarter capped off a year that few could have predicted. While risk assets continued their improbable sprint back from the depths of the Covid-19 selloff, market leadership shifted in the final stanza of the year. Though large, tech-related US companies had dominated index performance during the massive recovery that began in late March, the persistence of the “reflation” trade that emerged in September inspired a rotation into segments of the global equity markets that had lagged for much of the year. For example, the fourth quarter saw the outperformance of value over growth, small stocks over large, and international developed and emerging markets over the US.
Despite what ultimately was a successful year for asset returns broadly, we believe expectations moving forward should be tempered given pockets of rich valuations amid a range of structural risks. In our view, portfolios composed of soundly valued businesses complimented by gold as a potential hedge are a prudent way to participate in possible market upside while enduring the periods of distress we may encounter.
Equity Market Laggards Move to the Fore
While 2020 as a whole was a generationally difficult year for value investors, signs of a reflation trade that emerged in September persisted through year-end, driving the outperformance of value both globally (15.7% for the MSCI World Value versus 12.5% for MSCI World Growth) and within the US (16.3% for Russell 1000 Value versus 11.4% for Russell 1000 Growth) during the fourth quarter. Similarly, the full year underperformance of international stocks was pared back somewhat, as the MSCI EAFE Index outpaced the S&P 500 Index 16.0% to 12.1%, due in part to a weakening US dollar.1
Of course, the 12-month picture tells a much different story in a year when lockdowns drove the virtual economy up and the real economy down. While the MSCI World Index was up 15.9%, the growth component returned 33.8% compared to a 1.2% decline in value; this 35% spread almost defies belief given that the growth and value indexes have a long-term historical correlation in excess of 0.9. Spreads between growth and value were similar in the US, as the Russell 1000 Growth Index posted a 38.5% return during 2020 compared to the 2.8% return of the Russell 1000 Value Index.2
The pandemic provoked a near shutdown of the more mature, physical components of the economy—such as commodities, manufacturing and real estate—including those companies that tend to populate value indexes. In contrast, the pandemic-driven shift online for both business and personal commerce accelerated preexisting trends and provided a significant boost to the revenue and cash flows of new economy growth stocks with strong online presence. Despite the impressive business results posted by certain elements within the growth space, overall index performance in 2020 was driven primarily by multiple expansion. By year-end, the enterprise value/EBIT ratio of the MSCI World Growth Index relative to the MSCI World Value Index stood at the highest level since 2000.3
As long-term investors, we think it is important to take the right message from the strong broad market returns of 2020. As we’ve often cautioned, extrapolating trends is a risky way to commit capital, particularly when these trends reflect an extraordinary operating environment like that of 2020. Some of the factors that led to the extreme gap in valuation between growth and value last year have a natural elasticity to them and are likely to revert. The arrival of vaccines suggests there is a plausible path for economies to reopen within the next 12 months, to the potential benefit of the companies most directly impacted by 2020’s lockdowns—mature businesses operating in the physical economy. Further, more-normal conditions may make it difficult for certain growth stocks to maintain lofty valuation multiples as year-over-year sales and earnings growth comparisons become more challenging in 2021.
Low discount rates also have heightened the appeal of more speculative names, as investors see less opportunity risk in taking a flyer on investments that may pay big rewards down the line—or nothing at all. Frankly, we are concerned about the signs of speculative froth we see in paradoxically low credit spreads, in the torrid initial public offering market (including offerings of special-purpose acquisition companies, or SPACS) and in the many “concept” stocks that trade at valuations divorced not just from the reality of their current cash flows or revenue but also from any plausible expectation for five years from now.
Yellow Signals Ahead?
We believe it may be possible that market and monetary dynamics have reached a pivot point and that we could be heading into a period of significant risk for investors. If we analyze the pattern of money supply over the past 50 years—from the dissolution of the Bretton Woods agreement in 1971, to the deflationary impact of China’s entry in the global economy in the 1990s to any number of economic dislocations from such events as the dot-com bubble, the global financial crisis and Covid-19—we see a significant transition. While currency and government debt had once been exogenously constrained by either a link to gold or by a tough, independent central bank, it now is endogenously created to support fiscal deficits and private sector recapitalization, seemingly without fear of repercussion. This may seem like a free lunch, but there is no free lunch in economics.
With relatively fixed money supply, business cycles can be deeper, restructuring harsher and inequality greater, but there is less inflation and limited fiscal and trade imbalances, and longer-term productivity growth tends to be higher as a result. Without such constraints, short-term cycles are cushioned—as we saw most recently during the onset of Covid-19—but at the expense of growing monetary, fiscal and trade imbalances, all of which act as headwinds to longer-term productivity. These conditions ultimately may be realized in the form of a global bifurcation between regions with strong currencies and trade surpluses—like Japan and Europe and potentially even China in the years ahead—that may face deflation risk, and weak-currency, trade-deficit regions—like the US and the UK—that may be subject to stagflation risk. Net net, current policy dynamics offer the illusion of macro stability but also the potential for structurally lower real returns for markets in general and lower real productivity growth.
Maintaining Our True North
Though the dollar was strong early in 2020 as investors sought perceived currency “safe havens,” it has weakened steadily once risk assets began to rebound in late March and real interest rates—the difference between nominal rates and inflation—headed south. As the Fed slashed its policy rate to near zero, interest rate differentials between the US and other nations shrank, diminishing the appeal of the dollar carry trade. Meanwhile, through its embrace of an inflation-averaging framework rather than a hard 2% target, the central bank is likely to let the economy run hot to make up for many years of subtarget inflation. We think the combination of a weaker dollar and lower-multiple international equity markets creates a more favorable backdrop for us as global investors.
Gold also proved to be a useful hedge against the economic shock and the concurrent monetary debasement we witnessed in 2020. Gold hit a new high in nominal US dollars during the year, reflective of lower real interest rates and a weaker dollar. We don’t have a directional view on gold, but it is important to set realistic expectations for 2021. A stronger-than-expected recovery could inspire more-hawkish rhetoric from the Fed and lead to a stronger dollar and a backup in bond yields, likely impairing the value of gold. Having said that, we are maintaining a somewhat larger-than-average allocation to gold as a potential hedge to help chart a resilient course through a complex environment characterized by such destabilizing factors as lofty equity market valuations, high sovereign debt levels and global and local political instability. With sovereign rates likely to remain near zero as the money supply continues to grow unabated, cash is a less-appealing alternative to gold, especially if central bank efforts to promote inflation are successful. Finally, we are mindful of the new strains of Covid that have been emerging alongside the original strain whose impact has worsened through the winter.
True north for us remains the quest for sound real returns against the backdrop of a complex, unpredictable world. The rearview mirror shows a pattern of sound, resilient real returns for our strategies, which have neither been as weak as distressed markets nor as strong as the pockets of maximum speculative interest. The forward view is one where expectations for broader asset returns should be tempered, given high valuations and/or low yields amid structural risks from sovereign debt levels to geopolitics, monetary experimentalism and the ongoing pandemic. The quality and diversity of our stock holdings gives us conviction in this environment. Some participate in the new economy, some stand to benefit from a recovery of the more mature physical economy, and some are simply grind-it-out cash-flow-generative businesses—but all are quality companies at prices we consider sound.
Our approach to value investment begins with defining the character of a business before assessing its price. We believe owning soundly valued, real businesses and a potential hedge in gold is a prudent way to participate in the monetary melt up we are witnessing while fortifying against the pockets of distress that we will likely encounter.
