Reflation's Rollover Says Short SPDR S&P Oil & Gas ETF XOP. Part 1

10/17/2018 12:47 pm EST

Focus: ETFS

Landon Whaley

Editor, Gravitational Edge

In this week’s Macro Theme update, we review “Reflation’s Rollover.” Last week’s inflation bombshell is just the latest in a string of economic and financial market data indicating that the most likely path for U.S. inflation is lower, writes Landon Whaley Wednesday.

A downtrend in inflation against a backdrop of slowing U.S. growth sets up the perfect environment for shorting crude oil-related equities like those in the SPDR S&P Oil & Gas Exploration & Production ETF (XOP).

Fundamental Gravity says what?

Two chief variables impact the risk and return of asset prices: economic conditions and how central banks respond to those conditions. Together, these variables drive what we call an economy’s Fundamental Gravity.

In The Playbook from July 16 edition of Gravitational Edge, we said, “Despite everyone’s belief that inflation is pulling a Superman and going up, up, and away, we believe inflation—along with growth—will begin to slow towards the end of 2018 and heading into 2019.”

This slowing inflation call was made just after we received June’s inflation reading showing the fifth consecutive monthly acceleration in consumer inflation. Most investors (and economists) are prisoners of the moment and simply extrapolate what’s happened most recently forever into the future. Well, we aren’t most investors, and thankfully we aren’t economists, either!

Last week we received September’s readings for the three primary gauges of U.S. inflation. This hard data confirms that we nailed this call. Consumer inflation (CPI) slowed for the second consecutive month and is now back to the lowest reading of 2018 at +2.3. Core inflation has slowed from its July peak of +2.4% to +2.2% currently.

Finally, producer prices (PPI) have fallen off a cliff, having slowed for three consecutive months to a +2.6% pace, since peaking in June at +3.4%. The hard inflation data is officially trending lower across all the major indicators. But it’s not just the data backing our slowing inflation play; markets are confirming it in real time.

chart 1

One of the “purest” ways to gauge the market’s expectations for future inflation is to analyze the spread between Treasury yields and TIPS yields.

In this week’s FG chart you can see that the 5-year Breakeven Inflation Rate peaked at 2.16% on May 22 and has been trending lower ever since.

The 10-year Breakeven Inflation Rate is painting a slightly different picture. It peaked at 2.18% on May 15, trended lower until September and has bounced over the last month. That said, the one-month acceleration still hasn’t come within spitting distance of that May high.

chart 2

Treasuries aren’t the only market forecasting lower inflation ahead; the equity markets are singing the same song. The two most inflation-sensitive sectors of the U.S. equity market are metals & mining and energy stocks. The metals & mining sector peaked on June 7, has now declined -14.9% and experienced a maximum drawdown during that time of -16.1%. In the same vein, U.S. energy stocks peaked on May 22 and have declined -6.5% while experiencing a -9.0% drawdown.

These performance statistics are exactly what we expect to see during a period of slowing U.S. inflation. The markets are telling us in real time that inflation is heading lower, and the hard data is now confirming that signal.

chart 3

The Fundamental Gravity bottom line is that both lagging economic data and real-time markets are confirming that U.S. inflation is slowing for the first time in 12 months.

During this type of FG4 environment, XOP typically averages a -10.5% quarterly return with an average quarterly drawdown of -22.4%. In addition, it posts negative three-month returns 75% of the time. Bear market, anyone?

Reflation’s Rollover and Shorting XOP Part 2

This Friday, October 19, we will release part 2 of this commentary, which is where we will dig in to the other two critical forces, or gravities, that are currently impacting crude oil-related equities: Quantitative and Behavioral. We will also provide a detailed game plan for trading XOP.

If you can’t wait the 48 hours to get the complete picture for this macro theme and the accompanying trade details, please email us at with the subject line “Reflation’s Rollover – Part 2.”

We will provide you with the complete macro theme breakdown as well as sign you up to participate in a four-week free trial of our research offering, which consists of three weekly reports: Gravitational Edge, The 358, and The Weekender.

Watch Landon Whaley discuss When Markets Cycle in a short video here.

Landon Whaley: We have a generation of investors and asset managers who know only one market. The reality is markets and economies cycle and catch people off guard.
Recorded: MoneyShow Dallas Oct. 5, 2018.
Duration: 5:51.

Landon Whaley interviews trader Jackie Ann Patterson: How I got started trading and how I approach it with my Truth about ETF Rotation.
Recorded: MoneyShow Dallas Oct. 5, 2018.
Duration: 6:14.

Related Articles on ETFS

Keyword Image
Best Buys Among Microcaps
06/11/2020 5:00 am EST

If you’re an optimist on the U.S. economy and stock market, you may want to boost your exposur...