Last month, after much speculation, the Federal Reserve announced a more open-ended commitment to economic stimulus. This action, dubbed “QE III,” has significantly increased expectations of inflation and currency debasement of the US dollar. Previous episodes of such unconventional monetary policy have proven to be significantly positive for risk assets including equities, precious metals such as gold and commodities in general. As a result, we have taken profits from one of our successful art themes over the past few years and invested the proceeds into gold mining equities. The net effect of this rebalance is to increase the expected upside capture of our Market Risk building block while lowering its implementation costs.
We eliminated exposure to gold mining equities last year due to concerns about high input costs and lower profitability. Since then, gold mining equities severely underperformed gold bullion and other asset classes in Market Risk in general. Since QE III was announced, equities and precious metals have begun to rally but commodities have not, reflecting ongoing concerns about the extent of China’s slowing economic growth. This has helped contain the costs of production and boost the prospects for higher profits for gold mining producers. As a result, there are tentative signs of an increase in gold production. We believe gold mining equities now offer significant value in both relative and absolute terms. They are now at the cheapest level over the last decade, except during the panic lows of 2008/09. Markets are also acknowledging this valuation opportunity, because in recent months, gold mining equities have outperformed gold bullion and other asset classes in Market Risk consistently.
We have chosen to fund our exposure to gold mining equities from Master Limited Partnerships (MLP). After generating significant outperformance within Market Risk since we first established exposure in May 2010, several indicators are signaling that our thesis for owning MLPs has been realized and that it is time to take profits. These indicators include:
- Dividend yields on our MLP exposure have fallen to about 3%, a very low level relative to the history of this asset class.
- Though QE III is designed to help keep interest rates low, given the rise in inflationary expectations that have accompanied its announcement, we are concerned that interest rates may actually begin to rise more significantly than they did in QE I or QE II. Given the diminishing returns of successive rounds of quantitative easing in keeping interest rates low, the demand for owning MLPs for their higher than average dividend yield is therefore expected to weaken. There have been no significant net capital inflows to MLPs over the past few quarters, reversing the strong net inflow trend we have been watching over the past two years.
- Volumes of oil and gas, a key fundamental driver of this asset class, have declined as global economic growth has moderated. It is unclear whether QE III will be as successful in stimulating growth as the first two rounds of quantitative easing.
- There is some risk that the tax-advantaged status of MLPs may be questioned in the coming months as Congress debates a compromise on avoiding the “fiscal cliff.”
Given the strategic nature of the oil and gas pipeline infrastructure in our country as policy strives to achieve greater energy independence, we may decide to own MLPs again in the future. However, relative to the opportunity set other asset classes in Market Risk currently have to offer, MLPs’ current valuation and yield levels are not paying us to do so for the time being.