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Inflation is Lurking
03/20/2019 9:05 am EST
Our view is that inflation will soon pick up, which means you will need to reshuffle your investment portfolio, notes Landon Whaley.
In July 2018, all three primary gauges of U.S. inflation (consumer, core and producer prices) had been accelerating for six to 24 months, depending on the gauge. Based on that trend, the Old Institution and its followers were calling for inflation to ramp even higher for the remainder of 2018 and well into 2019. They simply looked at what inflation had been doing and extrapolated that trend forward.
But we said in “The Playbook” on July 16, “Despite everyone’s belief that inflation is going up, up, and away, we believe inflation—along with growth—will begin to slow towards the end of 2018 and heading into 2019.”
Rather than use the highly scientific technique of straight-line extrapolation, we had evaluated U.S. inflation using our models, which consider factors like base effects and the non-periodicity of economic data sets. We realized that inflation was likely to peak within two months and alerted you accordingly.
We were right, and the June/July time period marked the cyclical high in all three primary inflation gauges.
Here we are again, 34 weeks after that last inflation call, saying: U.S. inflation is bottoming, will begin accelerating, and will exert its influence on U.S. asset classes in the months ahead.
Our mid-2018 call for slowing inflation spearheaded our “Reflation’s Rollover” macro theme, which allowed us to successfully trade the short side of crude oil and crude-related equities, both of which crashed (peak-to-trough drawdown in excess of -20%) during the final three months of the year.
But that was then, and this is now.
We are awaiting confirmation from the Mongoose, but in the weeks ahead, we will be adding crude oil and crude-related equities to our list of preferred longs in the U.S. Shift Work macro theme.
As a reminder, U.S. Shift Work was activated last year when U.S. growth shifted from nine consecutive quarters of acceleration to a slowing regime. Since that shift occurred, we’ve been trading U.S. markets based on the economic reality that both U.S. growth and inflation are slowing in tandem, and the U.S. economy is in what we call a Fundamental Gravity #4 environment.
While the Old Institution and most investors focus almost exclusively on economic growth, the trajectory of inflation is just as critical to getting market calls correct. With inflation getting ready to perk up and U.S. growth continuing to slow from here, the U.S. is about to leave its FG#4 and enter a Fundamental Gravity #3 environment, which alters the playbook we’ve had in place for almost six months.
In addition to adding black gold and energy stocks to our list of longs, utilities are back in our good graces as well, with a dramatic improvement in their Quantitative Gravity and a track record of performing extremely well in an FG3 regime. Outside of those additions, we still want to be long REITs and homebuilders in the equity space. From a fixed income perspective, we’ll keep buying dips in Treasuries (all durations) and wait for an opportunity to back up the truck once the 10-year yield closes for three consecutive days below 2.626% (which, based on Friday’s close, could be any day now). The short calls for this theme remain the same: bang away on U.S. financials and basic material stocks on short-able bounces until further notice.
There are other markets, outside of those we’re focused on, that are impacted by this transition from an FG4 environment to an FG3.
Tech, industrials and consumer discretionary are three sectors that were strong shorts in the FG4 environment but are neutral in an FG3. Their risk-return profiles simply aren’t compelling from the long or short side in an FG3. During the FG4-in-Q4 environment, we loved consumer staples on the long side, but in an FG3 staples don’t move the meter either way. This is not meant to be an exhaustive list of all markets that will be impacted, but rather a sampling to show you that not all growth-slowing regimes are created equal and you need to trade accordingly.
For some reason, inflation is the red-headed stepchild of economic data, only getting attention when it ramps and threatens to turn us into Venezuela.
But despite not being one of the popular kids, inflation is just as critical in dictating the direction of asset prices as the trajectory of economic growth. Further, most don’t know that it’s the rate-of-change (ROC) of the data that matters most. Remember, the ROC gets you paid; navel-gazing “levels” gets you left behind.
Inflation is moving from a declining period to an accelerating period, which means the ROC of inflation is increasing, which changes the playbook for trading U.S.-based asset classes for the first time since last summer. Most investors are going to be caught completely off guard. Don’t be one of them!
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