Best Way to Build Wealth - Resilient Investments, Including Gold
[Music] Consuelo Mack: On WEALTHTRACK, noted Global Value investor, Matthew MacLennan on navigating the new era of higher interest rates and inflation. Matthew McLennan: We probably have one of the high levels of valuation risk I can remember in my career. Across many assets, it’s hard to dispute that we have one of the higher levels of geopolitical risks of the last generation.
We also have the risk of the debt overhang and it’s not just in the United States. It’s globally. And then we have the risk of policy credibility being brought into question. This is a risky constellation. Consuelo Mack: First Eagle Global Fund's Matthew McLennan is on Consuelo Mack WEALTHTRACK.
Announcer: Funding provided by ClearBridge Investments, Morgan Le Fay Dreams Foundation, First Eagle Investment Management, Royce Investment Partners, Matthews Asia, and Strategas Asset Management. [Music] Consuelo Mack: Hello, and welcome to this edition of WEALTHTRACK. I'm Consuelo Mack. We appear to be in a new investment era. One of higher inflation and higher interest rates. As these charts from First Eagle Investments illustrate, meaningful inflation has been largely absent in recent decades.
Since the early 1980s, we have been living through what's been called the great moderation. A long, multi-decade stretch of low inflation. That changed dramatically in the past year as the economic dislocations of COVID-19 kicked in. Consumer prices soared to 40-year highs driven by COVID lockdowns,
labor shortages, supply chain disruptions and record amounts of monetary and fiscal stimulus. In response, the Federal Reserve has pivoted from its unusual role as inflation promoter to its traditional role of inflation fighter, which means higher interest rates ahead. The major macro shifts like these are always turbulent. How to navigate them without damaging your portfolio or psyche is our focus today.
Our guest is uniquely suited to tackle this challenge. He is Matthew McLennan, a noted global manager, Co-Head of the Global Value Team at First Eagle Investments, where he oversees more than 90 billion dollars in assets, including several mutual funds. His flagship, First Eagle Global Fund, is rated four-star by Morningstar with a silver analyst rating for its unique approach, which has helped give the strategy a long-term edge. Since McLennan took over the fund from legendary value investor Jean-Marie Eveillard in 2008, the fund has far outperformed its world allocation category with considerably less volatility than the stock market. First Eagle is a sponsor of WEALTHTRACK. McLennan’s track record and reputation speak for themselves.
I asked him if he believes we are in a new era of higher inflation and interest rates. Matthew McLennan: Well, we may be in a new era Consuelo, but the paradox is that we have higher inflation, mid-single-digit inflation, but lower interest rates. And that's the paradox of the moment. And I think the way to interpret, I think what the bond market is saying right now is that the Fed does have to pivot to higher interest rates, but it's only going to be able to raise rates so far. Arguably because of the debt overhang in the economy.
And that's really what the bond market is trying to price right now. And that's an open question, because the longer inflation stays at these levels, the higher the risk that expectations adjust up. And the bond market is not pricing inflation expectations moving up. We're at a very delicate cuspy moment, one in which the credibility of policy is really facing a generational challenge.
Consuelo Mack: Talk about the debt overhang and how much that figures in to the Fed's thinking, which has the dual mandate of full employment and also price stability. Matthew McLennan: I don't think they look at the debt overhang explicitly. I think the Fed itself is very focused on financial conditions. And what we've seen over the last several economic cycles, is that the peak level of debt to GDP, and that is if we combine household debt plus corporate debt plus government debt and look at the total relative to GDP has been getting higher and higher. And again, this cycle, we’re higher than we were before COVID struck.
And what that's meant is that over the last several cycles, interest rates have peaked at successively lower levels because the economy has reacted negatively or financial markets have reacted negatively to lower levels of interest rate hikes. The Fed hasn't even really tightened policy yet. We're still in QE. The Fed has just signaled a more hawkish posture. And that's been enough to create a correction in the stock market. And the Fed is going to be attuned to changes in financial conditions, and
I think the bond market is relying on that taking care of business, if you will, as opposed to a higher level of interest rates. We're just going to have to wait and see. Consuelo Mack: We've talked in the past about the fact that the Fed has seemed really for the last 10 years or longer constrained by how the markets react. Matthew McLennan: In fact, Consuelo, it has been even worse than being constrained on the upside. If you think of the last few cycle, each time we've had an economic crisis, the Fed has had to resort to larger and larger measures of stimulus. First, it was zero interest rates, then zero interest rates, plus QE. This last time, zero interest rates, plus super-sized QE. The Fed has really been asymmetric in its policy response function. And I think that that can't
by definition, persist forever. And at some point, the credibility of policymakers will come into question, and I think that's the risk that we face at this juncture. Consuelo Mack: You’re always concerned about risks at First Eagle. What are the other risks that you're watching? Matthew McLennan: We'd like to look at when we start up is price, because price is subjective. And in some ways, the contours of 2021 were somewhat reminiscent of 1999. We had the stock market get to valuation levels that were at generational peaks. Consistent with the high levels that we saw in the late 1990s.
The second thing that we saw last year was not only low-interest rates, but generationally low credit spreads. We saw a very low cost of capital. And alongside that, the Fed didn't just succeed in reopening capital markets. There was a whole host of speculative activity. We saw concept stocks get to record valuations. In fact, the growth universe of stocks peaked only towards the end of last year versus the value universe of stocks. We saw IPOs for SPACs and new stocks that didn't yet have earnings to speak of or even revenues in some cases. And we saw the high yield markets wide open for issuance.
And the second risk I would say that we saw last year is that assets were priced for very low risk and that is its own risk. I think beyond that, I think everyone's aware of the host of geopolitical risks that we see out there in the world. Consuelo Mack: We've got Russia, China, Iran, North Korea most likely cooperating with each other, against the U.S., against the West, against democracies. It does seem like a very challenging environment. As a world allocation fund manager, how do you incorporate those challenges in the investment process? Matthew McLennan: I think these threats are one of the reasons we like to own part of our portfolio in a potential hedge like gold because I believe that the market is underpricing these risks. And
I think the final thing I'll just mention is that we've spoken a lot about monetary policy today, but the fiscal policy settings that we've seen have been every bit as extreme as the monetary policy settings. We saw double-digit fiscal deficits. I think more importantly than that, we saw a second round of fiscal stimulus even after business confidence had recovered. So it's going to be a really big challenge to restore fiscal credibility in the United States. That's going to be a headwind for many years to come. Consuelo Mack: The fiscal credibility. Who's judging their credibility? Where is that going to affect the financial markets? Matthew McLennan: I think we ultimately see credibility expressed in currency markets.
Consuelo Mack: Right. What kind of risk are you seeing in the dollar now, for instance? Matthew McLennan: The challenge for the dollar is that it's been strong for the last decade. Consuelo Mack: Right. Matthew McLennan: And the risk for the currency is that it's expensive. We expanded our monetary base more than other developed markets. We have a trade deficit and the question is if interest rates don't go up very much, are we going to attract the capital when there's an issue of confidence in policy that occurs at some point over the next couple of years? Consuelo Mack: Right. That's something you've been concerned about for a while, Matt,
and it really hasn't happened yet. How real is this risk and is it something that you're doing something about as a money manager? Matthew McLennan: I think it's difficult to continue as we are because as we discussed earlier on, the policy settings in each successive recession have become more and more extreme. Consuelo Mack: Right. Matthew McLennan: By definition, I don't think we're on a sustainable long-term path. Our preferred way of addressing these risks is to have a potential hedge in the portfolio and we express that through the ownership of gold. Consuelo Mack: As you're describing these extremes that you're seeing, has gold become, from your point of view, even more valuable to you in the portfolio? Matthew McLennan: If I step back and I just think about the backdrop objectively, we probably have one of the higher levels of valuation risk I can remember in my career across many assets. It's hard to dispute that
we have what one of the higher levels of geopolitical risks of the last generation. We also have, as we discussed earlier on, the risk of the debt overhang. And it's not just in the United States, it's globally. And then we have the risk of
policy credibility being brought into question. This is a risky constellation even though we're in the midst of what feels like a robust economic recovery. And it's for those very reasons that we want some potential protection against a tail state of the world. And it's fair to say that gold hasn't really been moving
much higher to price those risks. In fact, gold has de-rated since the middle of 2020. Consuelo Mack: Right. Matthew McLennan: And if we look at the price of gold, for example, relative to U.S. money supply and two, when we look at it relative to equities, the price of gold has retraced to levels that were consistent with when the Fed was at the peak of its prior tightening cycle, such as Q3 in 2018, or Q2 in 2007. Gold has in a sense discounted a certain amount of tightening in financial conditions. And I think
the question for gold is going to be: What happens next? What happens once the Fed tries to tighten? And or if any of these risks that we discussed start to surface themselves? Consuelo Mack: What does happen? How do you think gold will respond under those conditions? Matthew McLennan: In my opinion, the Fed is behind the curve. We have seven percent inflation. We're still doing QE. One or two things can happen in my mind that would constitute tail risk states. One is that we end up repeating the experience of the 1970s that Chairman Powell becomes the second generation of Chairman Arthur Burns from the early 1970s.
And that we get a period of stagflation. Now, during the 1970s, gold performed particularly well. It had its ups and downs, but it did perform particularly well over that decade. The other scenario that could play out is that the Fed remains committed in a Volcker-like way to restoring its credibility. In which case we might need substantially tighter monetary conditions than what the bond market is currently discounting. I think in that scenario, real assets would suffer initially and gold could even conceivably go down. But the question is would it fall by as much as,
say, equities if the Fed really jammed on the handbrake at that stage. And we think that the value of gold in those tail states of the world could perform reasonably well relative to equities. And because we're primarily an owner of equities, that's valuable to us from a portfolio construction standpoint. And I would just make the final point. There is always the smooth landing scenario. We'll wait and see. I think that's what the bond markets and asset markets are pricing right now, and I wish them luck.
Consuelo Mack: Matt, Morningstar describes First Eagle's approach as unique, giving it a long-term edge. Aside from your holdings in gold, which is a trademark of First Eagle, what else are you doing that's different from the world allocation funds? Matthew McLennan: At our core, Consuelo, was the notion that we would like to create resilient wealth over the long term. And when we talk about gold and we've given a lot of focus to it today. We need to put it
in the context that it's a minority of our portfolio. It exists as a potential hedge. And the path to resilient wealth creation for us is primarily through the ownership of businesses that embody some kind of scarcity value. And where we plant seeds, we invest and we hold for the long-term. Our average turnover is quite low. We’re nearly a decade horizon investor when we buy into businesses. We really aim to grind it out over time. We want to grow wealth relative to nominal GDP, but we want to do so in a way where we have an eye to what can go wrong so that when we have the inevitable crises along the way, our clients have the staying power to endure that and benefit from long-term compounding.
Consuelo Mack: You just mentioned scarce and durable assets. Can you name a couple of companies that represent those scarce and durable assets that are in your portfolio now that you've held for a long time? Matthew McLennan: Yes. If you look at our largest equity holding, it's a company called Oracle. They're the world leader in relational databases. And their business is transforming to cloud delivery. They're annuitizing their business. The rate of growth in their business is also accelerating as they're going through that transition.
And it speaks to the fact that not only do they have this sticky, stable market share position, but it's priced in a way that the arithmetic works. The company today has a free cash flow yield, arguably north of six percent. And you get the benefit of mid-single-digit growth, a six percent free cash flow yield, and a steady business over time. If I look around the world, we look for a range of different kinds of businesses. For example, the largest business that we own in our overseas portfolio is a company called Richemont. We used to own Tiffany's. It got acquired by LVMH.
If you want to own a leading jewelry Maison, you have to look internationally. And Richemont is the holding company that owns Cartier and Van Cleef. They also own IWC Watches and Piaget. All of these brands are more than a century old. That's an example of business duration. And the company trades at a discount to the valuation that LVMH paid when it acquired Tiffany's. Consuelo Mack: Prudent management, another quality that you look for. And I know that you
frequently invest in companies that are run by founders or founding families. Can you give us some examples of those? Matthew McLennan: Interestingly enough, the last two companies we just discussed have found a billionaire at the helm, basically. Consuelo Mack: Right. Yes, they do.
Matthew McLennan: And I think it's particularly important at this point in time. I described a macro environment to you that could be very uncertain in the next five to 10 years. And what matters to us is knowing that this management at the helm of these companies that have a track record of not just wealth creation, but adaptive behavior. So investing alongside a founder, I think, is a good way to make sure that your capital, the free cash flow that's being generated by those businesses, is going to be thoughtfully stewarded over time. And that capital structures will be robust. In fact, if you look at Richemont, it essentially has close to no net debt. It's very conservatively capitalized.
Consuelo Mack: Your value investors looking for that margin of safety and considering how expensive the U.S. market is, where are you finding those margins of safety? Where are you finding good value in the world today? Matthew McLennan: Last year, prudence was not particularly rewarded. Consuelo Mack: No. Matthew McLennan: And as you suggested, the US was at the epicenter of that. It's a dominant part of the benchmark and the MSCI World. It was also the hub of growth stock investing.
I think if you're looking to diversify and look for some opportunities elsewhere, that may be less in favor, I would focus on some of the Asian markets, for example. And in fact, Japan has been quite weak in resonance with what was a bear market in China last year. And not only is the currency weak and potentially attractive, as we discussed earlier on but a range of different companies are valued very conservatively. If I look at our largest stable type businesses in Japan. Companies like Seacom, which has over 50 percent market share in commercial alarm systems, or Mitsubishi Estate, which owns a third of the square footage in the Marunouchi, the prime CBD real estate in Japan. These companies trade at very modest valuations.
And there are businesses in other parts of the world that own special assets or market positions, and they may also be in currencies that are quite depressed relative to history. Consuelo Mack: Should we be looking overseas? Is that where you think the values are? Matthew McLennan: Look, we've found value in the United States. Consuelo Mack: Right.
Matthew McLennan: We own a range of U.S. listed companies that we think are attractive to own for the next decade. But I think it would be remiss of an investor to ignore the opportunity set overseas. The fact that the United States equity market’s nearly 70 percent of the MSCI World tells you that the average investor is actually not that diversified.
So I think now is probably a prudent time to consider some element of diversification because many of the currencies internationally are quite depressed relative to the dollar. It's not a call on where they go in the next 12 months, but if you're going to be an owner for the next decade, that's a good starting point. Secondly, the valuations of markets outside the United States are quite a bit cheaper than the US equity market. And if you're selective, you have the ability to find companies that either control special assets or are run by talented management teams. Consuelo Mack: I just want to go back to gold because when you're talking about your gold holdings, you don't just own the bullion, but you also own the gold miners.
Are there gold mining companies that one would consider to be sustainable and responsible and environmentally friendly? Matthew McLennan: When one thinks of the mining business, one doesn't naturally think of something that's sustainable in inverted commas. Consuelo Mack: Right. Matthew McLennan: But when you step back and you really think about this industry, this is an industry that's actually been around for literally thousands of years. There are very few industries that have shown the persistence of this industry. I think the second thing that's critical is that if you look at the large leading gold miners, whether they're royalty companies or their miners, they have to operate in all kinds of jurisdictions around the world. Consuelo Mack: Right.
Matthew McLennan: Social license is incredibly important. And I think the most talented management teams in the gold mining universe devote a huge amount of their energies towards finding the right balance between the local communities they operate in and the economics of the mines that they're running. You can't be a good miner without a social license. Finally, from an environmental and safety standpoint. A good mine is a safe mine. And
your social license is invariably tied up with the environmental footprint of how you mine. So I would say that many of these companies are far more thoughtful than you would think on these variables. Consuelo Mack: And which company has done particularly well among the gold miners? Matthew McLennan: One of our largest holdings in the space is a company called Barrick, run by Mark Bristow, who's got an incredible track record of creating value in the gold industry. And he inherited a range of social license issues. But I think if you look at their actions over the last couple of years, they've made meaningful progress on all of those issues. And I think it's a good example of someone trying to do right. They've also set a very clear roadmap
to carbon mitigation over time. They take this seriously and they believe it makes very good economic sense. It will position them on the right side of the cost curve long term. Consuelo Mack: ExxonMobil is also one of your largest holdings.
How do you view the energy and oil industry in particular and those companies? Both from an investment point of view and also from a sustainability point of view? Matthew McLennan: The fossil fuel industry has been the poster child for a pariah industry during the past few years. Consuelo Mack: Right. Matthew McLennan: There's no question about that. Having said that, one has to think at a second-order level. Ultimately, there
is a roadmap underway for people to transition the auto fleet to electric vehicles over time. But one can't lose sight of the fact that there are certain applications for which dense and portable energy still is going to require oil for a very long time. The reality is that the field decline rate in this industry that's been a pariah industry and where there's been substantial underinvestment, not just because of the ESG taint, but because of the low prices during the COVID crisis, has meant that there's been insufficient investment to sustain field life relative to the pace of transition. These companies need to exist. As you're thinking about investing as a portfolio manager, a real risk that you have to deal with is the price of the world's most consumed commodity going up a lot because of underinvestment. Consuelo Mack: Right.
Matthew McLennan: And there's a role for energy in a portfolio as a potential hedge. Meanwhile, what's going on at these companies is that they're arguably part of the solution. Exxon is a world leader in carbon capture technology, for example, and it's doing a lot of research into alternative fuels such as algae. They have new directors on the board who bring environmental change pedigree to the company. And the company trades at a very undemanding valuation. The thing I'd like to get across here is that when you're thinking about ESG, if I could give you analogy, think of the world of credit investing.
You make money in credit investing by finding a credit that's getting better over time. In the world of ESG investing, it's our belief as a value investor that ESG improvers could be a source of real investment opportunity. It's not just the history and the historical taint of a business that makes sense. It's what a management doing to improve the situation. Consuelo Mack: Matt, we always asked the one investment for a long-term diversified portfolio. Is there something we should all own some of? Matthew McLennan: I think a lot of the conversation today has centered around the importance of diversification in a moment like this. I think diversification is a key principle. If you want to own a technology company like Oracle, why not consider some tech leaders internationally like Fanuc and Robotics or Taiwan Semi in semiconductor foundry equipment? If you want to own a consumer staple in the United States like a Procter & Gamble, why not consider a Unilever internationally that's under an activist attack right now at a third less of the valuation? We've given a number of examples today of the ability to buy good businesses at reasonable prices outside the United States.
And I think now's the time to think about that from a long-term portfolio planning standpoint. Consuelo Mack: Matt MacLennan, always a treat to talk to you, and always appreciate your very thoughtful conversations as well. Thanks, Matt. Matthew McLennan: Thank you so much. [Music] Consuelo Mack: At the close of every WEALTHTRACK, we try to give you one suggestion to help you build and protect your wealth over the long term. This week's Action Point is adding some inflation beneficiaries to your portfolio. As just discussed
with few exceptions, gold has held its value. It also serves as a hedge against disaster. Owning the bullion through an ETF makes it more accessible. The SPDR Gold Shares ETF symbol GLD is the oldest. Other traditional inflation plays include a variety of commodities. A broad-based commodity ETF is the iShares S&P GSCI Commodity Index Trust, symbol GSG. Real estate is another traditional choice. Real estate investment trusts, or REITs, offer
shares in pools of income-producing properties. The Vanguard Real Estate ETF, symbol VNQ, provides low-cost exposure to a broad range of REITs. And finally, Treasury Inflation-Protected Securities or TIPS are U.S. Treasury bonds indexed to inflation. You can buy them directly from the government
or through an ETF like the iShares TIPS Bond ETF, symbol TIP. Now, most of these investments have been out of favor for years. They are under-owned by most investors. This is a good time to diversify into some inflation beneficiaries for the years ahead.
Next week, the bullish case for the market from influential economist Eddie Yardeni. In this week's extra feature, Matt MacLennan looks to the future with a book recommendation. Please follow us on Facebook, Twitter, and our YouTube channel. We so appreciate your spending time with us. Have a lovely weekend
and make the week ahead a healthy, profitable, and productive one.
2022-02-14 08:40
