Slowing inflation opens up a window to hedge portfolios ahead of a likely resurgence in price growth later this year.
The market continues to be splendidly untroubled by inflation. After a brief dalliance with concern around rising price growth in 2021 and the first half of 2022, the market has been happy to gorge on higher-duration stocks as if inflation is yesterday’s problem.
But this is woefully misguided. Inflation will return, with a re-acceleration likely late this year or early next year as China’s monetary and fiscal engines slowly shudder back into life.
The extra duration the market has taken on in recent quarters will become a millstone - as there is a greater prospect that rates may not return to their longer-term average as soon as expected - which is why currently out-of-favor lower-duration sectors such as energy and utilities are likely to outperform higher-duration ones through the shock of re-emerging inflation.
Tech hardware, software services and semiconductors are among those that have outperformed the most this year as AI fervor gripped markets, and are typically higher duration (using the inverse of their dividend yield as a proxy for it). At the other end of the scale, some of the most underperforming sectors have been lower duration, such as telecoms and energy.
This is in stark contrast to the period preceding last October’s low in the S&P, when it was lower-duration sectors that were leading, and tech and its cohorts were out of favor.
This reversal in fortunes came not long after US year-on-year headline CPI peaked last June. It has been falling rapidly since, with the market at first taking profits on sectors such as energy, and then going back into tech - slowly at the beginning, and then unrestrainedly after OpenAI’s release of ChatGPT 3.5 last November.
Rising duration risk is not just confined to equities. The market’s (i.e. the household and corporate sector) bond duration-risk has been rising too. As banks, central banks and the rest of the world eschew US debt, it is the corporate and household sector (principally the latter) that are absorbing it.
This across-the-board rise in duration risk is less of a problem in a regime of low-and-stable price growth. But inflation is not finished with us yet.
The reason is China. It was, and still is, China’s halting recovery that has driven most of the decline in US inflation. Splitting up US PCE into the components that are most sensitive to Fed policy (cyclical) and those that are left over (acyclical), shows cyclical inflation remains near its highs. All of the fall in inflation has been driven by the acyclical component, i.e. the inflation least sensitive to the Fed’s monetary actions.
In fact, acyclical inflation is highly correlated to producer inflation in China, and thus China’s inability so far to catalyze a durable recovery has been the core influence on the US’s disinflation. The chart below illustrates the underlying relationship clearly.
China has already been incrementally easing monetary and fiscal policy, and it will continue to do so until it arrests the slowdown currently besetting the post-pandemic economy. PPI will rise, and this will ultimately feed into US CPI, halting its fall and pushing it back higher.
It’s hard to know exactly when, but three to six months is a fair estimate, given youth unemployment in China is running at over 20%, and policy makers’ patience will be getting increasingly thin.
That leaves a golden opportunity for portfolios to be re-tilted back toward lower-duration sectors. Tech has become overcrowded, while lower-duration materials, energy and utilities are among the cohorts where investors are most underweight, according to BofA’s Global Fund Manager Survey.
Source: Bank of America
Energy is a particular standout. Not only is the sector currently unloved, it is the cheapest and second cheapest in relative price-to-earnings and price-to-book terms respectively. Moreover, it is typically the best-performing sector when inflation is elevated.
As the chart below shows, with US CPI color-coded for what sector has the best trailing 12-month performance, energy was often the best performer in the high-inflation periods in the 1940/50s and the 1970s.
Oil is another standout. Not only has the sector and the commodity itself been one of the best-performing assets (in real terms) though prior inflation regimes, the backdrop is currently very favorable.
Rising excess liquidity, topping out OECD inventories and increasing imports into China are all pointing to higher oil prices in the next 3-6 months. Recent news from Russia is a reminder that geopolitical risk is another reason to increase exposure to resources and resource-based industries.
Inflation is not a one-shot problem, and the risks are extremely elevated we have not seen the last of it in this cycle. Portfolios rotated toward real assets and with reduced duration risk will be much better positioned to weather the rebound than tech-and-bond-heavy ones.
