With institutional capital’s flight from hedge funds into the private equity sector, expect bl...
Inflation on the Rise
04/02/2019 12:25 pm EST
Mainstream economic analysis has seemed to forget about inflation, it is coming back, predicts 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.
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, which is why we said on July 16, “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.”
We were right, and the June-July time period marked the cyclical high in all three primary inflation gauges.
Here we are again, making a non-consensus call:U.S. inflation is bottoming, will begin accelerating, and will exert its influence on U.S. asset classes in the months ahead.
Our second half of 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.
That was then and this is now. 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 Fundamental Gravity #4 and enter a Fundamental Gravity #3 environment, which alters the playbook we’ve had in place for six months.
For crude oil and crude-related equities, the Fundamental Gravity #3 environment is second in bullishness only to the FG2. During an FG3, crude oil typically averages +5.0% per quarter, a drawdown of -16.4% and positive returns 64% of the time. On the equity side of the ledger, U.S. energy stocks gain an average of +2.2% over three months, experience an 11.1% drawdown and post positive quarterly returns 67% of the time. In addition, oil & gas exploration stocks (+4.5% return / -11.1% drawdown / 71% positive occurrences) are also a go-to energy industry on the long side in this type of environment.
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 or hurls us towards the next Great Sag.
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.
The ROC of inflation is about to shift from down to up, 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. The playbook for April is to buy the dip in crude oil, energy stocks, and oil & gas exploration companies.
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