The Fed is Flailing

And here’s one stock to take advantage

You can probably count on your hands the number of people still in the business who lived through it. And investment media rarely acknowledges the history if they’re even aware of the facts. But Federal Reserve policy to fight inflation from roughly the mid-60s to the mid-80s was almost entirely futile.

Conventional wisdom is the central bank was asleep at the switch until then President Jimmy Carter appointed Paul Volcker as Fed chairman, with a mandate to do what it took to crush inflation.

The reality is from July 1967 to August 1969—a decade earlier—the Fed did its best to crush inflation by raising benchmark interest rates from 3.79 to 9.19 percent, triggering a massive increase in borrowing costs. But when the central bank eased off, inflation surged again. That prompted an even more radical response from the governors: A lift from 4 to 13 percent between July 1971 and July 1974.

The increase plunged the economy into recession, wrecked the investment markets and was very likely a factor bringing down then-President Nixon. But sure enough, a year or two after the Fed backed off, the results were the same: Inflation came back stronger than ever, setting the stage for Volcker to raise rates from 4.75 percent to a peak of 20 percent.

Volcker’s actions pushed US unemployment to double-digits. And eventually a global depression was only prevented by an abrupt shift in Volcker’s policy to lower interest rates. By the mid-1980s, that switch too had brought on yet another inflationary surge, with gold prices reaching a new all-time high.

Volcker of course now gets full credit for bringing US double-digit inflation to heel. But while he likely did prevent a hyper-inflationary cycle in this country by restoring some measure of confidence in the dollar, I would argue that was just the necessary first step for what ultimately did break the back of the cycle: A vastly improved environment for global trade and investment, which eventually brought scarce supplies of everything from commodities and energy to housing back into line with underlying demand.

Raising interest rates radically to jack up borrowing costs did temporarily bring down inflation by slowing the economy, thereby reducing demand to  balance with supply. But the Fed also squeezed investment, so supply never increased to come back into balance with normal underlying demand. And when the economy rebounded again, scarcity increased, prices rose and inflation soared.

Hopefully, someone on the Fed is now noticing history is starting to repeat itself. And at least some are now making the argument that the Fed Funds rate has been increased enough for now.

But what’s already certain is their actions are having a decidedly negative impact on investment in energy, scarcity of which is a major driver of inflation. The September Producer Price Index announced this week, for example, came in well above expectations in large part because of higher energy costs.

Energy was also a driver of higher than expected September Consumer Price Inflation. Academic orthodoxy excludes it as well as food from so-called measures of “core” inflation, which in my view demonstrates economists get paid enough to not have to worry about buying food and energy.

ExxonMobil’s (NYSE: XOM) high premium takeover offer for Pioneer Natural Resources (NYSE: PXD) is bullish for our long-time Energy and Income Advisor recommendation. But while it’s been a huge winner for us, a good part of the appeal of uniting to form the leading Permian Basin oil and gas producer will be cost savings. In fact, in his initial comments following the deal, Pioneer CEO and Founder Douglas Sheffield actually said shale companies like his must “merge up” to survive.

Oil and gas companies have, of course, been largely cut off from capital markets on favorable terms basically since the middle of the previous decade. The need to self-fund all investment with operating cash flow became particularly acute in spring 2020, when worries about plunging demand briefly sent benchmark US oil prices into negative territory.

Small wonder then that oil and gas companies did not ramp up capital spending on new production when energy prices lifted off again in 2021 and especially 2022, instead using their free cash flow windfall to pay off debt or reward shareholders with big variable rate dividends and stock buybacks. And events this year have made them even less inclined to invest, as the Fed’s upward push on interest rates helped depress oil and gas prices by increasing expectations of a slower economy.

So long as the Fed keeps pushing up interest rates, it’s hard to see oil prices really ratcheting up from here. Natural gas, however, has made a big under the radar move this month, with benchmark prices now approaching the $3.50 per million BTU range after languishing under $2.50 for most of this year.

That’s a welcome move for natural gas focused companies, like long-time Conrad’s Utility Investor recommendation National Fuel Gas (NYSE: NFG). But it’s not going to be enough to convince producers to meaningfully ramp up output, rather than pay down debt, buy back stock, pay dividends and make acquisitions that help cut costs.

That’s the newfound discipline of US share. It means energy prices not only aren’t likely to fall much, even if the Fed pushes the US economy into recession. And energy companies are poised for big gains when the central bank ultimately declares victory, whether that follows a “soft landing” for the economy or outright recession.

Owning best in class energy stocks is one way to benefit from the past year and a half of Fed futility. Another is top gold mining stocks, the best example for income investors being Newmont Mining (NYSE: NEM).

Since the 1980s, gold and gold stocks have been very poor performers when the Federal Reserve raises interest rates. The 1970s through the mid-‘80s, however, were far different. Until the Nixon Shocks of 1971, the US dollar was pegged to gold at a fixed price. But after that, the metal ended every Fed cycle on higher ground. And gold stocks provided leveraged gains.

This past week, Newmont won final regulatory and shareholder approvals to merge with Australia’s Newcrest Mining (ASX: NCM, OTC: NCMGY), at one blow creating a company with 10 large, long life, low cost Tier 1 mining operations and some of the world’s largest deposits of gold, copper and other key metals.

Some considered the price paid to be too high, which has further discounted Newmont’s current price over the past year. But with $500 million in annual pre-tax synergies and an additional $2 billion in “portfolio optimization” targeted for the first 24 months after the close, it won’t take long to see the merits of this deal. And the higher gold prices go in coming years, the higher Newmont shares will. Ultimately, I expect a $100 plus share price for Newmont and dividends 2 to 3 times the current level.