As the market continues to be unconcerned with future price increases, a slower inflation rate has provided an opportunity for portfolio hedges. The market’s lack of concern about inflation is misguided. Inflation is likely to rise later this year or in early next year as a result of China’s slow recovery. As the market is heavily invested in stocks with a longer duration, such as utilities and energy, it’s expected that sectors with a shorter duration will outperform when inflation returns.
Key Points
1. The current slowing in inflation allows portfolios to be hedged before the anticipated price increase later this summer. Markets have been unconcerned with inflation and favored longer-term stocks. However, this is a misguided perspective.
2. It is possible that the market’s longer duration may be burdensome, as it is more likely than not that interest rates won’t return to their long-term averages as quickly as anticipated. It is for this reason that lower-duration industries like energy and utilities will outperform sectors with higher durations during a resurgence in inflation.
3. Duration risk does not only affect equities, but also bonds. The duration risk is being absorbed by both corporate and consumer sectors as the banks, central banks and rest of the globe move away from US bonds. The increase in duration risk may be less of a concern during periods of stable and low price growth. However, inflation will likely return due to China’s economic recovery and its impact on the US.
According to Bloomberg Simon White, macro strategist, says that slow inflation is a good opportunity for investors who want to prepare their portfolios ahead of an expected resurgence of price growth in the second half of this year. The market is largely unconcerned about the rising inflation that will occur in 2021, and the first half 2022. It favors stocks with longer durations.
White claims that this view is wrongheaded. China’s monetary, fiscal and economic engines are gradually recovering. This is why inflation will return. He suggests that the extra length taken on by markets in recent quarters may become a burden and that lower-duration industries such as utilities and energy are likely to perform better when inflation returns.
White points out the AI frenzy on the market has helped sectors like tech hardware and software services as well as semiconductors perform well. These sectors are more likely to be longer-term. Sectors like telecoms and the energy sector, which are shorter-term, have performed poorly. This is in contrast to the period before the S&P’s low in October, where lower-duration sectors led the way, and tech struggled. This reversal took place after US headline CPI peaked year-on-year in June. Since then, it has fallen rapidly.
Duration risk does not only affect the equity market, but also the bond market. As they avoid US debt, the household and corporate sectors absorb the duration-risk that was previously preferred by banks, central bankers, and other countries. White believes that even though rising duration risk may be less of a concern in an environment with low inflation and stability, inflation will not be over soon.
White attributes the drop in US inflation to China’s slowing recovery. The fall in US inflation is largely due to the acyclical inflation component (the part that is least sensitive to Fed monetary policy) and it’s highly correlated with producer inflation in China. White predicts that as China eases its monetary and fiscal policies to boost its economy gradually, producer prices will rise. This will eventually feed into US consumer prices, pushing them up again. White estimates this could happen within three to six month, as China’s youth unemployment rate remains high and policymakers are becoming more impatient.
White recommends that portfolios be rebalanced to lower-duration areas, given the potential of a re-emerging rate of inflation. According to BofA’s Global Fund Manager Survey, tech stocks are overcrowded while other sectors such as materials, utilities, and energy are underweight. The energy sector stands out because it is undervalued and unloved in comparison to other sectors. It also tends to do well in periods of high inflation.
White emphasizes oil as an asset that is attractive, noting its historical performance in real terms, during previous inflationary times. Factors such as increasing excess liquidity, declining OECD inventory, and increased imports into China, all point towards higher oil prices within the next three to six month. Recent news about Russia and geopolitical risk also supports increasing exposure to resource-based industry.
Final words White stresses that inflation is a long-term problem with high risks. Portfolios with a rotation towards real assets will be better prepared to weather the inflation rebound compared to portfolios heavily focused in tech and bonds.
