By John Davi
Diversification is always smart. However, sticking to the same allocations may not pay off in inflationary times. The inflation sensitivity of the assets you hold will factor heavily into overall portfolio performance. Certain cyclical stocks and commodities have traditionally fared better in times of high inflation and others have characteristics suited for Inflation 2022-style. The key is in the selection of the sectors and players most likely to benefit from rising prices.
Whereas 2021 was characterized by easy money, peak economic growth, and peak corporate profits, 2022 appears to be the opposite. Money is being taken out of the system, and the economy likely won't repeat the robust economic and earnings growth from last year.
We believe the current weakness in the equity and bond market can be attributed to a growth scare and not a full-blown pending recession. Admittedly, we have seen pockets of acute weakness in sectors such as long-dated nominal bonds, unprofitable technology, and hyper growth stocks. However, our base case is that this extreme weakness does not spread more broadly to all US equity sectors. Inflation-sensitive assets avoided the acute weakness and relatively outperformed in Q1.
Our view is that the Fed has been slow to react to the high growth of inflation and will lean on aggressive rate hikes to tame the stubbornly high levels of inflation. We estimate the Fed Funds effective rate could reach as high as 3% before this tightening cycle is over. From our perch, despite a large year-to-date rally in inflation-sensitive assets, such assets may still provide a level of portfolio protection and may have the potential to further benefit from higher levels of inflation.
Inflation was notably lower over the past decade as interest rates fell and the overall cost of capital was cheap. Our view is that these dynamics spurred the growth of the technology sector, which resulted in lower prices for goods and services and dampened inflation. Those forces are now working in reverse as interest rates and inflation are rising.
As a result of the deflationary forces over the past decade, inflation-sensitive assets were largely ignored as capital was allocated to deflationary sectors such as technology, consumer staples, and utilities, as well as nominal bonds. These asset classes performed well on a risk-adjusted basis, which enforced the concept of reflexivity. The better these asset classes performed, the more capital flowed into them. However, we think we’re entering in a paradigm shift where interest rates are on the rise and could remain structurally higher in the years to come. Under this new paradigm shift, assets that performed well when the discount rate was low may not produce the same level of risk-adjusted performance as interest rates rise.
Many inflation-sensitive assets are still trading at a discount compared to the broader US large-cap core index and growth indices. For instance, the S&P 500 Energy sector trades at a price-to-earnings ratio of 10.6 based on 2022 estimates while the S&P 500 and NASDAQ 100 index trade at 19.6 and a 25.5, respectively, based on 2022 estimates.
Admittedly, inflation-sensitive assets have seen strong returns over the past 12-18 months. That does not imply that the upside is limited, but we acknowledge that the rate of change could slow in the future.
As the inflation outlook remains heightened, investors will likely be paying strong attention to the US CPI levels. Moreover, the next FOMC Meeting is scheduled for May 3rd – May 4th. Market participants will likely focus on the possibility of any inter-meeting rate hikes, which could cause heightened levels of volatility if unanticipated. The size of the next increase, whether the hike is 25bps or 50bps, is also likely to be debated by the market in the coming weeks.
We expect heightening volatility to be one of the main stories for the balance of 2022. There is a direct linkage between easy money and lower levels of volatility. This reflexive concept is apparent when looking at the size of the Fed balance sheet, equity prices and implied volatility.
Moreover, the spread between the 2-year US Treasury and the 10-year US Treasury is close to inverting. This has historically sent an ominous signal to the marketplace. What does this mean for overall portfolio construction? We believe broadly owning a portfolio of diversified sets of asset classes, as well as owning multiple factors, inflation hedges, and alternatives will be paramount in 2022.
We believe there are three notable risks the economy faces:
The Fed is behind the curve
The Fed is looking to unwind its balance sheet at the same time it’s hiking interest rates, and
Inflation continues to remain high.
Will the economy be able to withstand these risks without going into a recession? Only time will tell.