You Mean, Like,... Metals?

In recent months, we have begun accumulating shares of companies that would benefit from reflation by the world's governments. In so doing, we have taken a stance decidedly contrary to the conventional wisdom that low inflation -- or worse -- will continue indefinitely. Indeed, the headline consensus has almost universally embraced a scenario of deflation.

"Deflation, anyone?"
"Producer and commodity price deflation prevails"
"Funds expect global deflation"
"Japan faces deflationary spiral"
"Commodity price index at 21-year low"
"No refuge in plunging commodities"

We have often made exceptional returns by taking well-reasoned stances against the investment consensus. If the majority of investors and the major headlines are wrong again, natural resource stocks, including producers of copper, forest products, nickel, oil, and gold stand out to be big winners.

These friendless stocks have underperformed the market averages by a wide margin - in many cases for several years. In our view, they are exceptionally cheap and contain very little downside risk. The timing of an upturn is uncertain, but we think it has a good chance of getting under way before year-end. As a result, natural-resources stocks now represent up to 15% of our portfolios.

Disinflation has had the upper hand since the early 1980s but has recently morphed into deflation because of the collapse in Asia. Commodity prices, including gold, are hovering at their lowest levels in two decades.

Deflation is a serious negative for financial assets. Put simply, dollar-denominated debt has become too difficult to service. Vast segments of the world economy are unable to pay back what they have borrowed. Unchecked, this trend would lead to more devaluations and outright debt repudiation. In Asia and Russia, where currencies have collapsed, there is barely any hope for repayment of the full debt burdens under current conditions.

Unless economic growth is restored, already staggering bad debt problems will worsen. Possible political repercussions, including adoption of anti-American, anti-free market policy changes, could follow. Unchecked, Asian economic problems will lead to declining profits, rising unemployment and a bear market in the US. Since the principal holder of debt is the banking system, another banking crisis could emerge. The dollar, which is at least 20% overvalued on a trade parity basis (according to the Bank for International Settlements), could decline precipitously based on a mere change in sentiment.

In short, if recent trends continue, they will become so painful and politically deadly that governments are likely to reach for the panic button. Growing concern over deteriorating economic and financial market conditions is therefore increasingly likely to bring about a U-turn in government policies.

In the US, if global deflationary symptoms persist and are perceived to be exacerbated by the dollar's strength, one can expect a reduction in short-term interest rates, a steeper yield curve, accelerating money supply and pro-growth economic policies -- including tax cuts and fiscal stimulus. With these new policies in place, the dollar should weaken relative to our trading partners' currencies and help foreign borrowers cope with dollar-denominated debt.

Japan will also embrace stimulative economic policies and restore strong economic growth. The policies already announced constitute a powerful stimulus: the main problem is that they have not been implemented -- hence the skepticism and continued caution on the part of consumers and investors alike. When the money earmarked for fiscal programs starts flowing, we expect a marked change in attitudes. And, should this fail to be the case, we expect the Japanese government to reach for the panic button and pass additional measures and funding.

Most important for our investment stance, Asia will increase its consumption of basic commodities. Asia is crucial to the outlook for basic commodities. In recent years, it has accounted for a disproportionate share of the growth in global consumption. There are two reasons for this role: GDP unit growth has been high, relative to more developed economies; and the intensity of usage per increment of GDP is much higher than in Western economies. This is because growth in emerging economies is much more dependent on providing physical goods to consumers than in the developed economies, where such demand is more saturated. And physical goods production requires raw materials.

Finally, very large hedge-fund short positions betting on further deflation will be reversed at the first sign of improvement in fundamentals, leading to sharp rallies in commodity prices. In a short period of time, today's conventional investment wisdom of slow-growth, low-inflation, bearishness on commodities and dollar supremacy will do an about-face. Capital will flow away from the US and Europe, and return towards the emerging economies, which will once again be perceived as offering attractive growth opportunities.

Important commodities that are sensitive to Asian growth include nickel, aluminum, copper, forest products, gold, and oil. We own shares in leading, low cost producers of these commodities, all of which would benefit from anticipated monetary policy changes through higher prices.

Summary. It is rare that our style of investing goes much beyond individual stock selection and broadens out into an industry or macro-economic theme. Originally, we accumulated positions in the shares of commodity producers, based on the attributes of the individual companies. We did not start with the macro-economic theme that ties these stocks together. However, it has been our experience that when our research process has lead us to a coherent economic theme consistent with our philosophy, the returns have been substantial for shareholders and led to a significant differentiation in our relative performance.

Examples would include our concentration in bank stocks in the early 1990's, and our focus on energy service companies in the mid 1990's. In both cases it was painful to be early, and we experienced the feeling of having very little company. We now look back fondly on the returns generated by those contrarian stances but tend to forget the discomfort of temporary underperformance and the pressure of contradicting the majority of "experts."

Based on the similarity to those experiences, we think our current posture toward natural resources will eventually prove highly rewarding to our clients.

John Hathaway

^©Tocqueville Asset Management LP. All rights reserved.
September 1998

This commentary is not an advertisement or solicitation to subscribe to the Tocqueville Gold Fund, which may only be made by prospectus. To receive a free prospectus, which contains more information on management fees and other expenses, call (800) 697-FUND (3863). Read it carefully before you invest or send money. The Gold Fund is subject to the special risks associated with investing in gold and other precious metals, including: the price of gold/precious metals may be subject to wide fluctuation; the market for gold /precious metals is relatively limited; the sources of gold/precious metals are concentrated in countries that have the potential for instability; and the market for gold/precious metals is unregulated. In addition, there are special risks associated with investing in foreign securities, including: the value of foreign currencies may decline relative to the US dollar; a foreign government may expropriate the Fund’s assets; and political, social or economic instability in a foreign county in which the Fund invests may cause the value of the Fund’s investments to decline.