US inflation & portfolio strategy
On Friday, we wrote about secular growth stocks, noting that in our view, we were only about “half to 2/3rds of the way through the de-rating” and that although Friday’s market close in Australia was a strong day for select tech, health, and growth stocks, the looming US CPI print could make holding over the weekend a fairly dicey proposition if inflation surprised further to the upside.
And, well, it did, as we thought it might; hence we expect a reasonably significant reversal of Friday’s performance at the market open.
Also, note we go on to talk about positioning at the end of the note.
The actual data print
That US inflation print. Mammoth. The possible sequential decline in core inflation is looking less and less possible-sequential-decline like.
Partly, we expected a surprise to the upside, given the impact of owner’s equivalent rent calculations (essentially shelter costs, calculated by pretending that homeowners pay a “rental dividend” to themselves, and this OER estimate is highly persistent and a significant contributor to inflation overall).
The other reason we expected an upside surprise was the impact of oil and gas prices over May, which, whilst excluded from core, have spill-over effects into other categories (because oil and gas are inputs to almost every process you can think of).
As others have noted, measures of expected inflation, anchored by years of monetary credibility, are now slowly grinding higher. The central bank tells you it will be low and stable, somewhere near 2%, and you believe them, as does everyone from you, your employer, and the firm’s CFO because the central bank holds all the keys to make it happen until reality compels them otherwise.
Households adapt if actual inflation continues to outstrip expected, month after month, and of course, this is highly problematic.
This next bit is complicated, but bear with us.
In economics, you draw little lines on a page representing aggregate demand, and aggregate supply, by positing relationships between them. For example, consumption is a function of your income. Investment is a function of the interest rate and expected future profitability.
Supply is a function of price relative to cost; for example, a firm’s expected mark-up over cost. Increasing prices with unchanging wages would lead a profit maximising firm to increase production.
That tends to mean that prices are what we expect them to be with some additional function that captures incremental demand. For example: Price actual = Price expected + (output actual – output potential).
And we draw these little lines on paper, subject them to shocks – a shock to monetary policy, or fiscal policy, or to “animal spirits”, and note what is happening to inflation, output, prices, and interest rates.
A central bank, attempting to ensure that actual output equals potential so that the economy is fully and appropriately utilising all its resources correctly, discovers that keeping the inflation rate constant is the one strategy that achieves this aim.
It’s a little astounding. It even has a name, the “divine coincidence”. If you want to maximise employment and output, keep the rate of change in the price level constant.
Astounding. That’s why every central bank everywhere is an inflation-targeting central bank. Because it just so seems (e.g. falls out of the model as a crystal clear conclusion) that keeping inflation under control means everything else magically takes care of itself.
(I’m writing as if it were a phenomenon with its own agency. It’s not, but it helps get the idea across.)
So, back the main points.
Back to the theory conclusions
If expected inflation remains well anchored, that price setting mechanism (Price = Price expected + excess or deficit of aggregate demand relative to potential) I described earlier is stable, and with it, the monetary inputs, like interest rates, which might only need to rise modestly to push inflation back to target.
If expected inflation is shifting higher because those inflations are incorporating the actual inflation rate, then the real interest rate keeps getting more and more negative, and monetary policy flies off the wheels.
That’s why the expected inflation or the 5y-5y breakeven inflation print matters. They show expectations are climbing, and that’s why the door is now open to a 75 basis point hike.
For the record, I don’t think we’ll get 75, but it is possible. Back-to-back 50s seem more likely, and that is more than enough to cause secular growth stocks to decline, which is much of how we are positioned.
The broader equity market can handle 50 bp hikes without selling off too heavily, but 75 changes risk appetites, and it is likely that everything falls in that scenario.
We’ve got plenty of alternatives in our portfolios; equity market neutral strategies, alternative risk premia strategies, and hedge funds that are very low duration with very low net equity exposure. We also have a lot of bonds, which, whilst they might be more correlated with equities than we’d like, are still falling by less than shares and thus provide relative downside protection.
Within equities, we’ve got a sizeable tilt towards value, which should help in a market where growth is selling off. We’ve also got active managers in the long-only equity strategies that are heavily exposed to energy (the part of the market holding up the best, given that oil and gas is half the trouble with inflation).
And, of course, we have plenty of cash on hand to deploy as well, which is helpful.
So our multi-asset portfolios should, as they are designed to do, continue to weather the storm quite well. As we did with our international equity sleeve during prior periods of market dislocation (European equities after the war began, emerging market equities after the property market and state champions regulatory-intervention fuelled collapse in China, Japanese equities after the yen’s implosion), we will likely add to stocks should they fall much further from here.
Our direct equity portfolio is also running a beta of .85x, meaning we should continue to outperform on down days, all else equal.
This is basically an edit, as I re-read my note, but I did want to make the point that inflation expectations, lifting or not, the Fed 100% retains the ability to hit the number it wants. They know it. It’s just that consumers, corporates, and everyone in between won’t like it.
If the Fed announced a 200 basis point rise next week, I guarantee that next month’s expected inflation print will come down. The month after that, the actual inflation print will come down. Paul Volker proved this in the 80s. It remains true today.
So I suppose that’s good news. We won’t become Zimbabwe (by all means, please insert your preferred geographical/historical precedent, Weimar Germany is a popular alternative). The bad news would be how the markets look under those conditions. But I suppose it is worth clarifying what the solutions and problems look like under different circumstances.
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