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Inflation is Coming, Trade Accordingly
11/08/2019 9:49 am EST
Inflation appears on the rise, which would change the fundamental gravity of markets, Landon Whaley has a plan for that.
Making decisions based on an investment philosophy of remaining data-dependent, process-driven, and risk-conscious helps cut through the ever-increasing amount of noise in financial markets and gives us the clarity to see shifts in both the economic and financial market data before the vast majority of investors. However, as we all know, there is no holy grail, and there’s no such thing as having it all figured out. Along these lines, one of the more challenging aspects of navigating markets is timing the shifts in the underlying Fundamental Gravity and being positioned correctly in the associated focus market calls.
As we’ve discussed before, transitions from one Fundamental Gravity environment to another are not points; they are processes. Right now, the U.S. economy is changing from Winter into a Fall Fundamental Gravity, catalyzed by an acceleration in inflation.
While consumer inflation (and producer prices) is not yet indicating signs of acceleration, the process of U.S. inflation breaking to the upside has begun. Core U.S. inflation has now accelerated for four consecutive months, and as of September’s reading is sitting at a 10-year high. The September ISM manufacturing and service surveys also confirmed an inflationary pick-up, showing that manufacturing prices have accelerated for three consecutive months, and service prices are at a 12-month high.
The final catalyst kickstarting the U.S. inflationary impulse is the comps. Beginning in November (and running through March 2020), the pace of inflation will be competing against the cycle low inflation readings from the end of 2018. In short, the year-over-year math makes it highly likely that consumer and producer prices will join core inflation and accelerate for at least the next four months.
Once we are confident the U.S. has made this transition into Fall, we’ll activate our newest macro theme.
While we aren’t ready to make it official, we want you to be prepared for what’s coming down the pike. At some point over the next two months, we will activate this theme and add several aligned focus markets. Let’s cover some of the potential “Reflation Elation” markets so that when they are added to our focus market list, or into the Gravitational 15 portfolio, you’ll understand the opportunity set.
Across the equity space, many directional biases change when an economy moves from Winter to Fall. One of the most dramatic changes occurs in energy stocks. During Winter, energy stocks have an average loss of 3.3%, max drawdowns of 14.1%, and only earn positive returns 36% of the time. However, when the economic weather transitions to Fall, energy companies average a 2.2% gain, drawdowns of 11.0%, and post profitable returns 71% of the time.
A Fall Fundamental Gravity is also one of only two FG environments where we take bullish positions in the commodity space. If we like energy stocks during Fall, then you know we like crude oil. During Winter, black gold is only positive 25% of the time, averages an 8.9% loss, and experiences an average drawdown of 20.4%. However, crude oil gets bulled up during Fall, posting positive returns 64% of the time, with an average gain of 5.0%, and an average peak-to-trough drawdown of just 12.4%. Energy isn’t the only commodity category that performs well in the Fall; we also like broad-based commodity exposure across grains, metals, and softs as well.
Contrary to popular belief, an inflationary environment is not the death knell for fixed income. We will continue to trade long-dated Treasuries and will likely bring back short-term Treasuries given that the Fed is behind the rate cut eight ball. But one thing is for sure when inflation rears up, you want to own U.S. Treasury Inflation-Protected Securities (TIPS). Depending on the duration, the average return ranges from +1.0% to +1.7%, but the positive hit rate (regardless of duration) is a rock-solid 87%.
While there are other markets we are considering on the bullish and bearish side of the U.S. market for the “Reflation Elation” macro theme, these are the four horses we’ll ride coming out of the gates: energy stocks, crude oil, broad-based commodities, and TIPS.
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