Inflation is always back of mind for investors, but it has come to the forefront these past few weeks – with a vengeance.
Market analysts and talking heads have been warning that inflation could begin rising as the country’s debt load teeters, government stimulus checks grease the economic skids, and a tipping point of vaccinated consumers rush out into the marketplace with fistfuls of cash.
Inflation is bad enough, they say. But it’s only one half of the equation; the rising costs of goods and services will prompt the Fed to step in and begin raising interest rates in an attempt to manage that inflation, increasing the cost of borrowing and dampening spending.
In short, slowing the economy.
Apparently, this kind of thinking has set the market’s collective hair on fire. It began as it always does with investors dumping Treasuries in anticipation of the coming storm, thereby pushing yields higher (bond prices move inversely to yield). That pace accelerated, catching many off guard, until in the final days of the month, growth stocks in general – and high-flying tech stocks in particular - were getting hammered. The thinking goes that high-growth companies dependent on easy borrowing will be hurt the most.
But wait – does it have to be this dire? Or can the bull market in stocks survive a rising inflationary environment?
Some folks think so. Jerome Powell for one. Testifying on Capitol Hill earlier this week, the Chair of the Federal Reserve generally played down inflation worries from another big stimulus bill and called the recent run-up in bond yields a reflection of investors' confidence in an economic recovery, not concerns about inflation.
“The economy is a long way from our employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved,” Mr. Powell said, reiterating a pledge to keep interest rates low for the foreseeable future, and to continue buying $120 billion in bonds per month until "substantial further progress" has been achieved.
Did that calm the markets? For a day or two.
Perhaps it’s worth noting that history shows when inflation (and yields) are rising for the right reasons, equities in general - tech shares and cyclically sensitive stocks in particular - tend to thrive. What are those “right” reasons? When it coincides with improving economic activity.
“Equities performed above-average in an environment where core inflation was between 1-4%,” said Larry Adam, chief investment officer at Raymond James.
[Sidebar: The annual inflation rate for the United States was 1.4% for 2020. The projection for 2021? Around 2.2%.]
“Since 1990, during rising rate environments,” Adam noted, “the average annualized outperformance relative to the S&P 500 and the percentage of time it outperforms the S&P 500 is largest for the tech, consumer discretionary and industrials.”
How about the higher dividend-yielding sectors like utilities, real estate and consumer staples? Well, they tended to underperform the broader market.
But the key is, the bull market continues even in the face of inflation - so long as that inflation coincides with improving economic activity. Which appears to be exactly the environment in which we find ourselves.
Would that historical knowledge help calm the markets? Maybe for a day or two. But the market needs a boogeyman lurking around every corner, and inflation fears – warranted or not - are about as good as it gets.
While we wait for the markets to regain a sense of balance and calm (insert laugh track here), the strategies will adapt and we’ll keep marching forward.
As noted before, long term, the strategies will get the trends right. Short term, there may be a miss or two as the market juggles conflicting signals. So keep allocations of strategies reasonable within your portfolio, and remember that protection[1 - see below] remains paramount.
Best always, David
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[1] What does protection look like? At the extreme, it’s cash. As I mentioned last month, it’s OK to hold some cash. Cash is, in fact, a position. It means you’re prepared to act when circumstances better align with your risk tolerance. Protection can also mean an overweight position in a model built for protection (i.e., Bond Bulls, The 12% Solution). It can mean putting multiple strategies to work in a portfolio, especially when those models tend toward an inverse relationship with each other, or focus on different asset classes or market sectors. Think Bond Bulls and American Muscle. Or Global Trader and The 12% Solution. Because each strategy uses a slightly different mechanism to identify market risks, and because each can employ different funds representing different market sectors (although there is obviously some overlap), there is beneficial diversification at work when using multiple strategies within a portfolio – helping to reduce volatility and max drawdown. Finally, protection can mean keeping an eye on the provisional picks during the month. These can provide a heads-up on potential trends -- and breakdowns of existing trends. Look for asset class shifts that hold up for a few days. Not every such move is a trading opportunity or justifies a rebalancing, but information is power.