The Labor Dept. announced that consumer prices rose 0.5% over the past month and 5.4% over the past year, explains Marvin Appel of Signalert Asset Management.

We are experiencing the highest inflation since mid-2008 (when oil reached $150/barrel) but the stock market greeted the news as bullish, turning small overnight losses in futures to small gains because last month’s 0.5% price rise was not as bad as feared. 10-year Treasury yields pulled back a bit after their bump from 1.17% to 1.34% from August 2-August 10.

Markets’ reactions in the lead-up to the last FOMC meeting on July 28 have since largely reversed (see chart below.). The dollar regained its July 23-29 losses while Treasury notes and TIPS gave back some of their recent gains.


Figure: Past six month’s total return in TIPS (TIP, red), 7-10 year Treasury notes (IEF, green) and the US dollar ETF (UUP, yellow). The circled period shows how these ETFs reversed their late-July moves, consistent with the notion that the economy will remain strong and the Fed will not be able to maintain current stimulative policies as long as they might have projected.

These observations, along with this month’s gains in cyclical sectors such as industrials (XLI) and transportation (IYT) rather than in technology (XLK), suggest that investors expect the economy to remain strong. (In a related observation, the tech-heavy QQQ looks vulnerable to a correction. As a result, the Fed might have to back off on quantitative easing earlier than Fed Chairman Powell might have anticipated or desired.

Another development consistent with the notion that the Fed will have to start taking its foot off the gas pedal is the recent drop in the prices of gold and silver. We saw silver’s drop on the August 9 hotline. Gold has dropped as well (see circled area in the chart below) and, like silver, is near a potential support level of 158 for the gold ETF (GLD), which corresponds to $1,680/oz, about 4% below where gold bullion is now trading. If you are thinking of taking a position in gold as a long-term holding for disaster insurance, this support area would be a reasonable place to buy.

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The corporate high-yield bond funds we follow for the newsletter portfolios (IHIYX and TGHNX) are down in August, so one might ask why corporate high-yield bonds are not confirming a bullish economic outlook. Fortunately, this month’s losses seem more to reflect generally rising interest rates rather than widening credit spreads. The spread between high-yield bond yields and Treasury yields hit a low of 3% in June before widening to a peak of 3.4% on July 19. High-yield bond spreads are now 3.3%, a bit below the long-term historical average. While IHIYX is down 0.4% so far in August, investment-grade bonds (VBMFX) are down 0.8% and the iShares three-seven-year Treasury note ETF (IEI) is down 0.6%. It would be an economic warning sign if high-yield bond spreads were to widen further but for now, it appears safe to ride out the recent pullback in accordance with our high-yield bond timing models that remain on buy signals.

Implications

Inflation in 2021 remains high. The markets are acting as if the Federal Reserve will attempt to keep it under control using only moderate measures that won’t interfere with economic growth. Observations that suggest that markets expect the Fed to pay some attention to inflation but are not fearful of an overly aggressive Fed response to high inflation include:

  • Small-caps recently keeping pace with large-caps, and equal-weight S&P 500 (SPX) firming up relative to cap-weighted S&P 500
  • Large-cap value recently recovering some lost ground relative with large-cap growth
  • 10-year breakeven inflation remains 2.4%, near its May peak of 2.5% and its highest sustained level since 2013
  • Recent softness in gold and silver
  • Recent strength in the US dollar

In other words, markets appear to be pricing in a goldilocks scenario where the economy is not too hot and not too cold. In this scenario, high-yield bonds should remain more attractive than investment-grade bonds and diversified equity exposure should have a better risk-adjusted performance than either growth or value alone.

Although small-caps might outperform in a vigorous economy, I do not believe that the potential level of outperformance justifies taking on the risks of investing in small-caps in what appears to me to be a mature market advance.

To learn more about Marvin Appel, please visit Signalert Asset Management.