In the wake of the hot January CPI print, I have had a number of discussions with readers about the most advantageous way of positioning an equity portfolio in a rising rate environment. The most obvious strategy is to use an allocation similar to the Rising Rates ETF (EQRR) is to tilt towards value and cyclical stocks.
Beneath the surface, however, such an approach carries considerable risks owing to growing negative divergences. Instead, I present a framework for managing the inflation tantrum of 2022.
Rising inflation concerns
The main investor concern today is the prospect of higher interest rates. Not only has the Fed revealed a tightening bias, but also the European Central Bank recently made a similar pivot. The economy is on fire and there is plenty of room for the Fed to raise rates. Job postings are strong and the data underscores Jerome Powell’s comment during the January FOMC press conference about a tight labor market.
I think there’s quite a bit of room to raise interest rates without threatening the labor market. This is, by so many measures, a historically tight labor market. Record levels of job openings, of quits. Wages are moving up at the highest pace they have in decades. If you look at surveys of workers, they find jobs plentiful. Look at surveys of companies—they find workers scarce. And all of those readings are at levels, really, that we haven’t seen in a long time—and, in some cases, ever. So this is a very, very strong labor market, and my strong sense is that we can—we can—we can move rates up without,without having to, you know, severely undermine it.
Moreover, consumers are spending again. These are the signs of a robust recovery that allows the Fed to tighten without worrying about tanking the economy.
While concerns over inflation and monetary policy are very valid today, there is no need to panic. Hockey legend Wayne Gretzky famously said that he skates to where the puck is going to be, not where it’s been. Here is where I believe the puck is headed.
How to position today
The most obvious way to address current market worries is to position for rising inflation and rising rates. The main overweight positions in EQRR are value and cyclical sectors. But a more detailed analysis of the relative performance of value sectors reveals a number of shortcomings to this approach.
- Most of the value sectors are in relative downtrends compared to the S&P 500, except for financials and energy.
- The relative performance of financials is showing a negative divergence to the 2s10s yield curve. Historically, financials perform better in a steepening yield curve environment because banks borrow short and lend long. A flattening yield curve is normally a headwind for this sector.
- The superior relative performance of energy stocks is attributable to rising oil and gas prices from geopolitical risk over Russia-Ukraine tensions. Exposure to this sector amounts to a bet on war breaking out.
In short, exposure to value sectors carries considerable risk. Investors are betting that the relationship between the yield curve and financials has decoupled. As well, energy prices will remain elevated or a Ukrainian war will break out.
A better way to position equity portfolios in the current environment is overexposures to defensive sectors and high-quality stocks. Three of the four defensive sectors have been in relative uptrends, which began in December and before the onset of the latest market pullback.
There are many ways of defining the quality factor. SPHQ is an S&P 500 quality factor ETF that calculates quality based on the fundamental measures of “return on equity, accruals ratio, and financial leverage ratio”. Another way of defining quality is profitability. S&P has a higher profitability inclusion criteria for index components than Russell and the relative performance of similar large and small-cap indices from the two providers shows the effects of the profitability factor. However it’s defined, the quality factor began to outperform in late 2021.
Investors can also observe the effects of the quality factor when viewed through the value and growth lens. While value stocks have recently led growth stocks mainly for the reasons mentioned previously in the discussion of value, high-quality value has beaten low-quality value and high-quality growth has led o low-quality and speculative growth.
In the wake of the latest hot CPI report, Fed Funds futures are discounting a half-point rate hike in March, five rate hikes in 2022 for a total of 1.5%. These expectations go beyond St. Louis Fed President James Bullard’s call for a full-point hike by the July FOMC meeting.
As a consequence, the yield curve has been flattening as short rates rise. So far, the bond market has exhibited a bear flattener in which both short and long rates rise but long rates rise less than short rates.
Someday soon, long rates will stop rising and begin to decline. The transition will be difficult to time precisely, but that should happen as the market prices in a Fed policy error and the rising risk of a hard landing. Historically, the 10-year Treasury yield has been roughly correlated with the Economic Surprise Index (ESI), which has been falling. As the Fed tightens and ESI declines further, indicating a weakening economy, bond yield should close the gap and begin to fall.
Historically, the relative performance of large-cap growth stocks, as measured by the NASDAQ 100, is inversely correlated to the 10-year Treasury yield. Falling long rates will see market leadership rotate from defensive sectors to growth stocks.
The next phase of market leadership can be described as the recovery phase. As the economy slows and inflationary pressures ease, the Fed will shift to a more accommodative monetary policy. That will be the signal for investors to rotate to value and cyclical stocks. For the time being, these industries are mostly weak to trading sideways relative to the S&P 500, with the exception of oil and gas stocks because of geopolitical tensions.
While it’s difficult to precisely forecast the turning points, investors should begin to overweight large-cap growth when 10 and 30 Treasury yields start to decline, which I expect will happen during Q1 or Q2. The recovery phase should begin when inflationary pressures begin to roll over.
Much of the inflation pressure can be attributed to shortages from supply chain bottlenecks. A recent snapshot of 28 exchanged-traded commodities shows that almost 20 of them are in backwardation, where the front month price is higher than the second month. Backwardation is an indication of a short-term shortage but history shows that such spikes don’t last very long.
Here is another sign that the inflection point is just around the corner. While the 5s30s nominal yield curve is flattening (red line), the 5s30s breakeven yield curve has already inverted (blue line). Even though nominal headline CPI is 7.5%, long-term inflation expectations are falling. Don’t be surprised if the Fed pivots back to a more accommodative monetary policy in H2 2022 as inflationary expectations remain well-anchored.
In conclusion, the current market environment is tricky to navigate and investors will be faced with considerable volatility in 2022. As it’s difficult to precisely time turning points, I suggest investors adopt the following positioning for their portfolios today.
- Overweight defensive sectors.
- Overweight quality stocks.
- Neutral weight high-quality growth, which should be the next market leadership.
- Underweight value and cyclical stocks.
25 thoughts on “A 2022 inflation tantrum investing roadmap”
In your conclusion, did you really mean “Overbought quality stocks.” or did you mean Overweight…
Yes, overweight not overbought.
Will be corrected.
One sector of Value that is apolitical and of the highest order of global necessity which is just now starting to outperform is Agriculture. Here is one of my momentum charts on its ETF (symbol MOO);
Last year, the President of Sri Lanka dictated that agricultural methods in the country must change to organic. He saw that organic food would be more popular and higher priced for their export markets, especially rice. It was a complete disaster. Crop yields plummeted drastically and the government had to subsidize farmers who were going broke. The country had to borrow massively on international debt markets. This failed experiment will show the global agriculture industry that modern farm methods, especially fertilizers, are needed to feed the world and get food prices down from their punishing inflationary highs.
There is one stock in the top list of MOO that I consider the best investment in the world today.
BTW, as I always say, nothing here is a recommendation since I don’t know your circumstance or risk profile.
which one is the best? of course no recommendation! 🙂
We are still in “Investment winter” overall, I guess?
I’d rather not recommend an individual stock for possible legal reasons. There are a miriad of cross-border regulations in the investment industry.
But you should be able to guess from my clues.
Hi Ken, how long do you think the ‘winter’ will last?
Winter until the first day of Spring.
That was like Spring Fed pivot Jan. 2019 and then later the Spring Covid Vaccine Day Nov. 2020.
Spring (the beginning of a long growing season) just doesn’t start because we’ve had a patch of bad weather and the sun comes out briefly. The Equal Weight S&P 500 is down just 2.7% from the November 19, 2020 peak. True, certain regions (Innovative Growth) have been hit with some freezing but not the country. Old Man Winter (the Fed) hasn’t even started to send the arctic cold front down (higher rates). There is just talk and nasty weather forecasts.
Go buy some warm winter clothes and lots of logs for the fireplace. This could be a long, cold winter. Let’s hope not an Ice Age.
Only when the inflation high pressure zone passes, will real Spring be in the air. Only a blind optimist would be counting the weeks to then. A true optimist would be counting the months. A realist wouldn’t even start counting for fear of getting too melancholy.
Would love to hear your reasons for a long, cold winter. I am expecting some turbulence and air pockets over the coming weeks and possibly months. But it seems that even the talking heads on CNBC and Bloomberg are already speculating about a Fed policy error. Powell is unlikely to rush into a 50bps rise in March. He knows the economy is highly leveraged. Too large an increase risks a recession and even worse. Raising rates won’t fix the supply-chain; it may only dampen the demand. The cure of high prices is high prices. Demand will probably slow down because of high prices, the lack of Covid-related fiscal stimmie and gradual improvement in supplies.
There is a possibility that this is just a high-wire act by the Fed and the administration in front of the mid-term. They need to be seen to do something about the inflation.
My 2c worth on MOO
I figure if Ken is talking about Fertilizer, then it could be Bayer. Or even closer to home for Canadians, Nutrien. They are both top holdings of MOO. Just a guess.
MOS, CF, NTR. Spot prices are thru the roof, mainly because of escalating natgas price and limited mine supply. So DBA is thru the roof too. But everyone needs to eat. It’s global. Nobody knows where it ends. It is very similar to end of 2007 and early 2008. Bayer is a seeds company.
I think Ken is implying DE (just guess). DE has morphed into an ag big-data company, not the traditional ag equipment company anymore. Today they are super high tech. They might become google of ag business. If you are bullish on DE, consider TSCO too. Small farms will only lease, not purchase.
Latest outlook on the pandemic from Bob Wachter:
The way I read it, it’s not over ’til it’s over – but we’re getting close.
The one concern lies within the historical context of the Spanish flu.
Dou you have in mind examples of quality stocks and high quality growth? Any ETFs? Or are you thinking about hand picking?
Make hay while sun shines, otherwise hunker down. A small example of ADBE, a quality stock and a company with a robust buy-back program. But now a share price drop of 33% in two months. When market participants are clueless, inexperienced, scared, trigger-happy, on and on …, why play?
I may be interpreting it incorrectly but Ken is positioned for an imminent recession while Cam is cautious about the outlook but not expecting a recession till possibly 2023. His ideas for how to position the portfolio reflect that.
There are so many astute investors on these pages and they have some probabilities for different outcomes. I am keen to hear some views.
We are more optimistic inspite of our long years. There is roughly one third chance in our estimation that Fed gets it wrong. Cam is watching the macro, geopolitical and other developments closely and will warn of the market going into a recession.
Jim Bullard is a typical example of sheltered out-of-touch-with-reality geek/egghead. You can find tons of them in academia and gov. They are part of the connected elites, shuffling between colleges and gov. And these people are in charge of the most important policies of our country. It is not surprising we are in such a mess and nobody has any confidence in our gov. Next up would be scientists. If they continue to sell out they will eventually be grouped with used car salesmen and ambulance chasers. Then will have achieved maximum randomness. Job well done.
As we look back at our portfolio, a handful of stocks have provided the bulk of the returns. Challenge is always to hang on to the quality growth companies in good times and bad. Regret selling many companies that turned out to be high quality growth and keeping companies that were miserable.
Are professionals any better?
Warren Buffet is a quintessential quality company buy and hold. It is as good as an ETF at zero expense ratio and no dividends. No recommendation!
Yes, BRK has done quite well since the beginning of 2022. It is (imo) a high “quality” stock.
Sanjay, you ask my reasons for a long cold Winter. The most obvious and almost impossible statistic to argue against is that EVERY time the Fed has raised rates at the speed the Fed Funds futures are rising, it has ALWAYS caused a RECESSION. Recessions, as Cam has mentioned are bull market killers.
Since the November peak, the EW S&P 500 is down 2.7%. Does that constitute ‘killed’ ? No. It is a slight scratch early in the stock market wars.
The bull story is the stock analysts future earnings estimates being very robust looking out a year. Those earnings do not envision a recession. People tend to just project the current trends into the future. Stock analysts get ostracized by the companies they research if they are negative. Being optimistic about earnings is not bad early in a new economic cycle but it’s a disaster for investors when recession storm clouds are on the horizon. I subscribe to RecessionAlert, the best service (and bloody expensive) for this. There are definite problems developing. ERCI, the other experts are becoming cautious, Leading economic indexes including U.S. and Europe are falling. Here is the chart;
The number of international country leading indicators that are falling has risen to past pre-global recession levels.
So Sanjay, envision the time it will take to first, the Fed starts raising interest rates over several meetings my guess into 2023, the economy starts to slowly react, Investors initially buy the dips because they have been trained to, but then they sell as the economy slips into recession and earnings estimates are lowered.
The Nov. election goes to the GOP. Biden want government spending to stop the recession. GOP blocks it to make the DEMs look bad for 2024.
The Fed eventually decides enough is enough and if fiscal spending won’t happen because of gridlock, to stop the economic and stock market pain, they will act in some massive way.
Bingo – Spring and the start of a multi-year bull market.
That is a long cold Winter my friend.
BTW, I am not, repeat not, a permabear. I was 100% equities and a super bull from November 2020 Vaccine Day TWIST (Start of Spring) until backing off in November when Autumn arrived. I am a weatherman who calls it as it comes not as I wish it to be.
Just like we are seeing terrible real weather events (floods, droughts, fires etc) because of Global Climate Change in the background, I see overarching factors in Global Investment Climate Change causing severe Winter weather (hopefully not an Ice Age). They are the huge buildup of global debt because of artificially low rates kept down too long. Also, stocks and home prices are overinflated for the same reasons. We have a shift to anti-globalization. The forty year decline in inflation could be over with nasty outcomes if Central Bankers try to stamp it out too quickly.
All that and we are down 2.7% from the peak in three months. Buy some warm clothes and lots of logs for the fireplace.
Thank you very much. That was very helpful. I can now see where your call for a long winter is coming from. I agree with most of what you said.
One thing I like most about is Jay Powell’s ability to pivot if the data changes. As you said, RecessionAlert and ECRI are already getting a bit concerned about the economy. I am sure the Fed has access to similar or possibly even better data and analysis. The Fed will likely raise the Fed Funds rate in March and possibly more to stave off inflation and score some political brownie points. But they will need to stop the rate rises before the higher rates choke the economy.
Spring may come sooner. I am not a macro analyst, so I won’t even speculate on a multi-year bull market. Leave that to experts like you and Cam.
Thank you so much Ken!
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