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Trump’s Fed Feud; Indexing Capital Gains Taxes to Inflation?
Pelaez: Time to Position for a Decade-Long Bull Market in Natural Resources
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Welcome to this week’s Market Wrap Podcast, I’m Mike Gleason.
Coming up we’ll hear a wonderfully fascinating interview with first time guest Samuel Pelaez of Galileo Global Equity Advisors. Sam highlights what he views as a tremendous investment opportunity in commodities right now, and also talks about how the markets may be getting it wrong when it comes to the trade wars and the likely impact it will have on the U.S. economy, inflation and the dollar. Don’t miss a tremendous interview with Samuel Pelaezel, coming up after this week’s market update.
Precious metals markets faced additional modest selling pressure this week as the Federal Reserve telegraphed two more rate hikes to come before year end.
As of this Friday recording, the gold market shows a 0.4% weekly decline to trade at $1,219 an ounce. Silver is currently valued at $15.55 and is now flat for the week. Platinum is up 1.1% at $844. And finally, palladium is down 1.1% with prices now trading at $922 per ounce as of this Friday morning recording.
Well, at Wednesday’s policy meeting, the Fed held its benchmark funds rate steady at 2%. However, policymakers reiterated previous indications that they intend to continue hiking rates, with the next one likely coming in September.
Additional tightening would put the central bank at cross purposes with the goals and priorities of the Trump administration. President Donald Trump recently called for the Fed to keep interest rates low. Fed officials may now feel that their jealously guarded independence is being threatened and that they must reassert it by raising rates in defiance of the White House.
The Trump versus Fed feud will likely heat up again next month, assuming we get another rate hike. The potential upshot is that an agitated Trump may reintroduce calls to audit the Federal Reserve. Trump had made Audit the Fed a part of his campaign platform, but since being sworn into office he has neglected to push it.
Fed chair Jay Powell opposes greater transparency to the public in in the name of… you guessed it – independence. That’s really just a code word for secrecy. In reality, the Fed has never operated independent of political and banking interests. It has just kept it secret from the public.
The way much of the news media portray it, Donald Trump is breaking with longstanding tradition by trying to influence monetary policy decisions.
The reality is, most presidents have exerted pressure on the Fed privately through various means. Lyndon Johnson reportedly went so far as to physically push Federal Reserve Chairman William McChesney Martin against a wall to try to intimidate him into backing off on interest rate increases. And Alan Greenspan notoriously entered into a gentleman’s agreement on policy objectives with the Clinton administration to ensure he would get reappointed as Fed chairman.
The only way to take politics out of monetary policy is to take away the power of a small handful of central planners at the Federal Reserve to determine interest rates. If the free market were left to determine borrowing costs, then no amount of lobbying by banks or strong-arming by politicians would make a difference.
For now, though, the Fed remains under pressure from the White House to stop hiking. The Trump administration believes it can counter the negative effects of tightening to some extent with more stimulus from tax cuts.
This week the Treasury Department announced it would look into making an administrative change that would index capital gains taxes to inflation.
Under the current system, investors are taxed on the full amount of their nominal gains on assets. For example, if you bought $10,000 worth of stock shares or gold coins in 1988 and sold them all today, you would owe taxes on gains that include 30 years’ worth of inflation. Gold prices are about three times higher today than in 1988. But that’s mostly because of inflation – the loss of purchasing power of the dollar over that period.
If your gains were adjusted for inflation, then your tax bill would be much lower – or perhaps even nil. And the government would no longer profit from pumping up the inflation rate. That’s the idea behind the Trump administration’s push to index capital gains taxes to inflation.
It would certainly be a big step toward bettering some of the unfair distortions caused by inflation. But it wouldn’t stop the inflation problem at its source – that being the relentless expansion of the currency supply by the Federal Reserve.
As the late economist Milton Friedman once put it, “Inflation is always and everywhere a monetary phenomenon.”
Well now, without further delay, let’s get right to this week’s exclusive interview.
Mike Gleason: It is my privilege now to welcome in Samuel Pelaez, CIO and Portfolio Manager at Galileo Global Equity Advisors, a Canadian subsidiary of U.S. Global Investors. Sam manages Galileo's Growth and Income fund as well as the Technology and Blockchain fund and also follows the natural resource and gold mining space quite closely. And it's a real pleasure to have him on with us today.
Sam, thanks so much for the time and welcome.
Samuel Pelaez: Thanks, Mike. It's a great pleasure to join you. I think this is the first time.
Mike Gleason: Yeah, absolutely. Excited to get a chance to talk to you finally. You've been talking about commodities being way undervalued. You published a chart back in the spring showing the value of the S&P GSCI Index of commodities companies relative to the broader S&P 500 Index. The ratio is near all-time lows. Since that chart was published in April not a great deal has changed, so talk about where we're at here in commodities now and give us your thoughts on what the value proposition looks like today because they certainly have been laggards compared to the broader markets.
Samuel Pelaez: Yeah, absolutely. That's my favorite all-time chart I think. I'm a big proponent of commodities and natural resource investing. Keep in mind, that chart goes over 60 years or so of markets. We've had cycles like this three times or this will be the third time. Twice in the past we’ve seen that sort of extreme rating where commodities are so undervalued relative to the broader market as measured by the S&P 500.
What that suggests is that we may be at a juncture here that provides an opportunity to invest in resources that we haven't had for over 20 years. Last time this happened was coincidental with the NASDAQ 1990-2000 boom. That was the time when the commodities were as undervalued relative to the broader market. And what happened since was obviously the big industrialization of China commodities did very well for a decade up until 2008 and even a little bit further than that.
So, it was at least a decade of commodities out-performance relative to the market. And we're in a similar predicament right now and that keeps me very excited. Now, if you think about short term especially since the spring, there's been a lot of talk of the trade wars. Commodities have sunk most of them quite dramatically, especially those that are sort of core to development of China. I would call those short-term deviations in the bigger and broader context. I think this chart is a very powerful indicator for investments over the next decade.
That may not mean that today is the bottom or tomorrow, but as any responsible investor, I would suggest to start reallocating some of your broader market exposure towards commodities just on the back of what this chart is saying. Now, the short-term deviations that we've seen can be very material. Copper is over 20% drop from its highs. Same story with zinc. Gold has also under-performed quite dramatically. But in general, I believe we are approaching a situation with that under-performance is unsustainable.
Frank at U.S. Global put out a piece a couple of weeks ago that was actually very insightful. And it said, "Let science drive your investing." It just shows how gold is two standard deviations below its mean. Copper is 3 1/2 standard deviations below its mean. And in statistical terms, that's a very sort of powerful indicator for a rebound. Just to say in a little bit more plain language, what that suggests is, there's a 95% probability that gold rebounds in the next 60 days. And in copper, it's more like a 99% probability that it rebounds in the next 60 days.
So, maybe we're just towards the tail end of this short-term trade war inflicted sort of under-performance. And then maybe we can start recapturing the uptrend that we've seen over the last year or year and a half that could, I hope, translate into a decade-long bull market for natural resources and commodities.
Mike Gleason: Of course, our focus here is on precious metals, you alluded to gold of course. They often trade like commodities. Particularly silver which has significant uses as an industrial metal. But gold and silver are also monetary metals. They can get more attention from investors looking to hedge against inflation or as a safe haven. Given that, what are your thoughts on where the precious metals might be headed? Do you think they will be pretty well correlated with commodities in the months ahead? Or, are you looking for them to perhaps behave differently, Sam?
Samuel Pelaez: The answer is yes. I expect them to perform very well. Gold is actually one of the more puzzling asset classes so far this year because it's under-performed. With the whole trade war angle, China and the U.S. at odds. President Donald Trump being at odds with some of Canada, some of the U.S. allies including Canada. That should be a pretty good environment for gold. But what's happened is the markets have interpreted the trade war as a positive economic impact to the U.S. and we've seen the U.S. dollar rise. And that's generally negative for gold on the other hand.
That's also been sort of turbocharged for lack of a better word, by the fact that the U.S. continues to raise rates at a much quicker speed than its peers in Europe or in Japan. The 10-year yield in Japan today is as close to zero as it gets. The euro is already at 3%. So that interest rate disparity has also helped the U.S. dollar be pretty strong year to date. I think that's going to stall and I'll tell you why.
Number one, inflation. Gasoline prices if you've been to the pump recently you've seen that from July 4th last year to July 4th this year, gasoline prices have on average risen about 50%. And that's inflation. That measure is not captured by the inflation metrics that the markets use. But, it's captured by the inflation that all consumers in the U.S. pay. So, inflation is creeping in so it's going to be starting to chip away from that 3% 10-year yield that's larger than that you can get in Japan and other places.
And the second one and perhaps more important is, I think gradually the markets are going to start turning and accepting the fact that the trade war angle could be detrimental to the U.S. We've seen General Motors come out with a profit warning. We've seen Alcoa come out and issue a profit warning on the back of the trade wars. And this is just the companies that have started reporting so let's wait another couple of weeks where most of the S&P 500 reports and see how many times the chairman and CEOs of these companies actually comment on the trade war being a potentially negative impact to the U.S. economy and to corporate earnings.
And circling back to gold, that may take some of that very strong support that the U.S. dollar has had year to date, which conversely should be very positive for gold. If you correlate that to what I mentioned earlier about the charts that show gold being two standard deviations below its mean, then we're in a predicament where over the next two or three months we may see a strong rally in gold prices.
Mike Gleason: Yeah, extremely well put. I agree that maybe the markets don't quite have it right and there's maybe a lot of pent-up inflation coming. Obviously, the U.S. economy has not really felt much of these trade wars and that may be coming. That's very well summarized there.
Now, I'd like to switch gears a little bit and get your take on the overall health of the markets in general. Around here we wonder how “real” markets are these days. For starters, we have central banks here and around the world heavily involved in markets. Interest rates are centrally planned. And these days it is commonplace for central bankers to be buying corporate stocks and even bonds for that matter. Then there's the mounting evidence of more underhanded activity. Bank traders colluding to rig prices in everything from metals to LIBOR and to cheat their clients. In recent years the advent of high-frequency trading has raised concerns that retail traders may not get a fair shake.
So, we have a pretty dim view when it comes to the honesty and fairness of markets. That said, we rely on exchanges such as the COMEX and want to believe they can still work. Give us your thoughts, Sam, on the integrity of markets since this is the first time we've had a chance to get your thoughts on the subject.
Samuel Pelaez: This is a subject that we discuss internally quite a bit. I do believe there is a fair amount of market manipulation. That's a very strong statement to say, but there's facts that support that, right? There's multiple banks have been, for lack of better word just risk locked. LIBOR, the gold market rigging, FX. There's factual evidence that some of the banks have been actively manipulating markets.
But that's just one of the angles from it. I think a second angle which is not manipulation but just an effect of passive investing is ETFs continue to raise capital and ETFs, the majority of them, are market cap weighted so they only allocate money to the top of the market. And that creates a sort of self-fulfilling bias for certain stocks that become market darlings and they receive more dollars, so they out-perform so then they receive more dollars. And it becomes like a vicious circle of out-performance.
That's because there's a lot of academics who are very interested in the subject and are writing about it. I think the term they coined for this is the passive investment paradox because the more dollars that go passive, the less dollars that go active essentially. And we start getting into this complacent type of markets, which I think we started to see especially in the broader indices in the U.S. like the S&P 500 and the NASDAQ.
Now, that may have started to crack. I think we can talk about it in a second. But before or after I complete the answer to this question, but we think ETFs have become a problem. They've hit that sort of like momentum and size where they've started to disrupt the natural flows of money in the markets. I agree completely with you about the LIBOR and FX manipulations.
But then lastly, and you did mention COMEX and I'm glad you did, because I don't know if people are aware and I don't think they are, when you buy a gold futures contract on the COMEX, it specifically states that you can redeem in kind. Meaning you can actually show up to COMEX and demand to be paid in physical gold. The problem is… and this number fluctuates… but there's about 400 contracts for every ounce of gold. Meaning if just one out of 400 people show up to reclaim their gold in physical form, the COMEX vaults would be completely empty.
So, there's this false perception that this paper contract from the COMEX actually represents one ounce of gold. It actually represents one four hundredths of an ounce of gold. And that in a way is a form of manipulation as well because it inflates the number of contacts. It inflates the liquidity of the sector. It inflates the supply of gold that realistically in physical form is not there.
These things worry us. They concern us. But, what we're really focusing on in our investing is allocating capital to sustainable companies that have higher than average return invested capital. We are supporting businesses. We're supporting management teams and we believe that the better ones will be able to surface amidst this market manipulation and still be darlings for a lot of investors.
Mike Gleason: Sam, among other responsibilities you manage the Galileo Technology and Blockchain Fund. Cryptocurrency has been a big topic in the precious metals space. Many people who look at gold as sound money have taken interest in Bitcoin and other cryptocurrencies for some of the same reasons. We at Money Metals Exchange do significant business both selling metals and taking crypto in payment and vice versa, buying metal and making crypto payments. Do you think a cryptocurrency offers genuine potential for widespread adoption as money? What do you make of the comparison between Bitcoin and gold?
Samuel Pelaez: Let me turn the question around. I don't believe that Bitcoin and gold are the same thing as has been purported by other market participants. I believe gold has a unique status and it's had it for a long time and it has a lot to do with its physical properties. Gold is the only metal that you can store for decades and then come back to it and it looks exactly the same. It doesn't rust. It's essentially oxygen proof, rusting proof, among other things.
You cannot say that about Bitcoin or a paper wallet of Bitcoin or a physical wallet of Bitcoin. So, I'm not subscribing to that thesis that cryptocurrencies are a store of a value akin to what gold is. I do subscribe to the thesis that blockchain technology… and I think tokens are just one representation of blockchain technology… blockchain technology is transformational for multiple industries. The payment processing industry or the barter industry let's call it, is obviously the most ripe industry for disruption from this kind of technology and that's what Bitcoin has done and Ethereum in the field of crypto have done, is create a secondary market for transactions outside of the fiat world.
It's much more efficient than gold at that because you can trade it instantaneously with people anywhere in the world which is something that you can't really do with gold in its physical form. Now, what do I think about the technology going forward? I think it's going to disrupt virtually every industry. And people probably heard it before. This is the internet all over again. We're only starting to learn how deep this is going to get. And also, think about it from a consumer perspective. The internet came about very late. But, for decades now or least two or three decades, when you pay anything at the supermarket and show it to the cash register, that's an Oracle machine with internet all through the back connected to a number of devices that make all of it possible. If you're at Walmart, then it automatically connects to the suppliers and updates the inventories and the unit numbers so they can place orders.
The internet has been amongst us for a long time. And I think blockchain technology would be the same. Now, Bitcoin, Ethereum and the other ones we can see as consumers. But the real transformation I think is happening in the business to business world. We're involved in a number of companies that are doing some incredible amount of work that will facilitate business to business. Not payment transfers but all sorts of technological processes that will completely disrupt the way things are being done right now.
What I'm trying to convey is that sense that this technology is not just limited to payment processing and money transfers. That's just one of the sectors. There's dozens and dozens of other sectors where these this technology will transform the way we do our business going forward.
Mike Gleason: Yeah, very interesting technology and that I think is the bigger story here: the blockchain technology much more than say, yeah, just Bitcoin as a cryptocurrency for instance. Well, as you know, we've had Frank Holmes on a number of times here on our podcast and he's talked a lot about the gold royalty ETF, ticker symbol GOAU here in the U.S. and GOGO there in Canada. I know you played a big part in the research behind that. So talk about mining royalty space here, Sam, and why are you guys so excited it. And also, talk about the fund's performance over the first year or two now.
Samuel Pelaez: Absolutely. We are big proponents of the royalty model. We think it's a superior business model relative to the miners. They also fit one of the key characteristics in everything you look for which is return on invested capital. The return invested capital in the royalty companies is exceptional. I warn you though if you just calculate the ratio on Bloomberg or any other data source, the return capital may appear lower than it actually is.
And that is because these companies have spent so much money forward in projects that will generate cash flows in the future. But, if you take them on a project-by-project basis, any investment they did and what they're deriving out of it, the returns are spectacular and they come at a very low risk. So when you sort of risk adjust then they're even better than they are in absolute form. So, we're big proponents of the model. We've been big supporters of the formation and the ongoing marketing of these companies. Frank was involved in the seeding of what became Wheaton Precious Metals which is the second largest royalty company out there right now.
So, what we decided to create was an ETF that offered investors that alpha generation that the royalty companies have offered us, over the full business cycle. We've noticed that many people only invest in gold when they think gold's going up. We actually believe that everybody should have an allocation to gold throughout the business cycle because it has this diversification properties relative to the other components of your portfolio given to broader the market.
So, what product could we offer our investors in the market that would allow them to invest across the full business cycle and deride all the benefits of gold investing without some of the detriments? And we created this ETF that's overweight the royalty companies because they offered that intrinsically and then after that it holds a number of gold producers that also have very high returns in invested capital and generally trade at a discount to their peers.
We believe that's part of the magic sauce. There's a few other factors that they're clearly listed on the marketing materials, you could get those at the U.S. Global website or at the Galileo Funds website. And what we've been able to achieve and I want to make sure that this doesn’t sound promissory, it’s actually based on the one year of performance, is the data of the ETF to the upside as in how it moves to the upside relative to the gold sector is about one for one.
So when gold starts to go up, owning our product or owning any other product is about the same. It's when the markets go down that our ETF goes down by a lesser amount than the competing products. And then when you bootstrap that difference over a long time, it creates a very big spread above performance. So far for the one year, our product beat the GDX by about 8%. That’s a pretty… I call it… a pretty impressive alpha generation. The fund also has a lower management fee and it has a lower standard deviation or pretty much every other risk metric is inferior.
So, we're very confident that it will continue to do that. The back tests suggest that it can do over the full business cycle. And I encourage your listeners to go and have a look because we're very proud of what we've created.
Mike Gleason: Yeah, you should be. It's done very well and it's exciting stuff and I love the model as well, you guys have done a great job putting that together and the research behind it. Well, as we begin to close here, Sam, any final comments? What will you be watching most closely in the months ahead? Maybe give us a final synopsis on commodities and metals as we wrap up.
Samuel Pelaez: I'll give you anecdotal piece of evidence. I had some friends visit from Colombia, where I'm from originally. And the first thing they mentioned was, and they looked at all the cranes and they said, "Wow, there's so much construction going on." And I guess because we live in North America and we see it all the time, we don't really recognize it every day. But, just think about all the wonderful things taking place in terms of… if you travel to New York often you've seen the big transformation that's taking place at the airport at LaGuardia.
I'm sure in all your communities and your cities you're going to see major projects being built. President Donald Trump has made a big focus of his presidency to roll out a major infrastructure plan. So, we're going to need these commodities. It's not like we achieved that peak moment of commodity demand. Commodity demand continues to go up every year. It's almost like GDP growth. So we will need these commodities. And right now you have the opportunity to buy them at one of the cheapest relative valuations that you've had in the last 20 years. And if you're like me, I wasn't investing – I wasn't old enough to be investing in the '90s – this is the best entry into the resource market that's ever been presented to me.
And because it only happens every 20 or 30 years, over the course of a professional life. You may only have one or two of this big macro cycles. So, I encourage listeners to follow that chart. We publish it very frequently every six or eight weeks as part of our marketing materials. I invite them to think seriously about reallocating some of the capital from the broader market. The S&P and NASDAQ have been a phenomenal investment over the last nearly decade, since 2009.
So, maybe it's time to start rolling some of those profits and rolling some of that allocation from some of the sectors that have out-performed into the sectors that have under-performed. And I believe over the next decade you will be handsomely rewarded for that.
Mike Gleason: Very good way to wrap up, very well put. Really enjoyed the conversation today and appreciate you sharing your market insights with our audience. Before we let you go please tell people how they can learn more and how they can reach you and your firm if they're so inclined.
Samuel Pelaez: Absolutely. The easiest way to reach is through our website GalileoFunds.ca. We're based in Toronto, Canada. I do travel to the U.S. a lot to speak at conferences, I travel a lot with Frank at U.S. Global. You can find all of our contact information and our fund fact sheets on the website. You can also follow us with social media. We have a LinkedIn page. We have an Instagram account. We're catching up to the times and finding all the new ways to reach the new demographics and to be out there for people to find us.
Mike Gleason: Well, good stuff. Thanks again, Sam. Keep up the good work. Continued success there and I hope we can speak with you again in the future. Take care.
Samuel Pelaez: Thank you, Mike. Bye, bye.
Mike Gleason: Well, that will do it for this week. Thanks again to Samuel Pelaez, CIO and Portfolio Manager at Galileo Global Equity Advisors. For more information visit www.GalileoFunds.ca.
And be sure to check back here next Friday for our next weekly Weekly Market Wrap Podcast. Until then, this has been Mike Gleason with Money Metals Exchange. Thanks for listening and have a great weekend everybody.