As regular readers will know, I’ve been trying to provide some useful signals and ideas for investors worried by surging inflation trends. My column last week in Citywire HERE tried to give some initial thoughts but every day brings some new research. This week it’s the turn of macro strategist Ian Harnett of Absolute Strategy Research for instance who’s been talking about inflation trends with the fixed income ETF specialist Tabula Investment Management.
Like many the respected Hartnett points to loose monetary and fiscal policy, the world economy moving from globalisation to autarky, and a significant, predicted increase in capital expenditure over the next decade. There’s also the growing strength and influence of China on the global stage, with its policies and actions increasingly affecting global markets. He says that in many areas, China is now more influential than America and is winning the battle for global dominance.
When discussing inflation, Harnett says monetary and fiscal policy in the US are among the most accommodative since the 1950s, and they are likely to lead to asset price inflation. He also cites a growing focus on national security. As countries become more focused on issues such as bio-, food-, cyber- and financial-security, a desire for countries to be self-sufficient will likely push prices up. The issue of rising prices due to a shortage of certain food types in the UK following Brexit is one example of this. The third major trend driving inflation, according to the Absolute Strategy Research co founder is a predicted huge increase in capital expenditure from companies over the next decade.
These views are of course dependent on the inflation curve heading upwards over the medium term – which I think is by no means guaranteed in a 3 to 6 month perspective.
US transportation inflation is not surging
One useful contra indicator comes in a weekly macro blog from US-based strategist Stephen Gallagher at SocGen on transportation prices which involves which comprises 16.6% of the index. The CPI minus transportation is running at a 1.7% yoy pace. “Moreover, this ex-transportation measure is not showing much acceleration at all.”
In terms of key components, SG looks at the following:
Motor vehicle prices – “Gasoline costs are up 55% on a yoy basis and added 2.1pp to the 4.9% pace of CPI gains. Gasoline prices are extremely volatile and frequently contribute to wide CPI variation. In spring of 2020, gasoline prices were soft and have bounced sharply. With crude oil trading above $70/bbl, however, we are not anticipating sustained gains on gasoline prices. In fact, risks may be more evenly divided to the downside as well as upside.
Used car and truck prices: “Even more than new car and truck prices, used vehicle prices are soaring. After nearly a year of lockdown, household flush with stimulus funds, fixated on vehicle purchases. Shortages due to car-fleet sales, low inventories and production setbacks due to bottleneck constraints have combined to create a shortage to meet the demand surge. But how sustainable? Used vehicle prices are adding 0.9pp to the CPI. Hence together, gasoline and used vehicle prices are adding 3.0pp to the 4.9% yoy inflation rate.
Remainder from transportation? “If headline if up 4.9% and gasoline and used vehicle prices are adding 3.0pp, the net of those two items is 1.9%. We calculate ex-transportation at 1.7%. There is a 0.2pp remaining contribution from transportation that is split among new vehicle prices, insurance, and airfares. These contributions while smaller may be more sustainable, at least in the medium term. Airfares, in particular, should benefit from a resurgence of travel demand.
The bottom line ? I don’t think we should take it for granted that the current inflationary surge will last too much beyond the end of this year. But if it does become more sustained, how should investors reposition their portfolios?
European Equities set to prosper says Morgan Stanley
Helpfully European equity analysts at Morgan Stanley, led by Graham Secker and Matthew Garman have just produced a report (What’s the impact of higher real yields?) which digs a bit deeper into what investors can expect from different markets in an inflationary environment. They’ve found that:
“Equity markets have become more sensitive to real yields post2018. Over the long run there is very little relationship between real yields and equity markets; however, since 2018 we can observe a link to equity valuations (the P/E ratio has become inversely correlated to US real yields) whereby a move to our 12-month target of -45bps for US real yields would imply one point drop in headline equity P/E ratios.”
The Morgan Stanley analysts suggest that their US bond strategists are forecasting US 10-year real yields to rise to -60bps by the end of this year and -45bps in 12 months’ time. If that is the case we should we expect a meaningful fall in share prices.
“Based on the post 2018 historical link between these two series …a move up in US real yields to -45bps over the next year would imply a modest de-rating of around 1 P/E point for both MSCI ACWI (from 18.7 to 17.7) and MSCI Europe (from 16.6 to 15.7). Ignoring any change in EPS over that period would imply a c.5% drop in equity prices”
In terms of geographies these rising real yields reinforce the equity analysts view that investors should be overweight stance on European (and Japanese) equities in relative performance terms….
“has been positively correlated to both real and nominal yields since 2018; the data also show that the US would likely be the region most adversely impacted. Consequently, the relative performance of MSCI Europe versus the US has closely tracked US real yields in recent years; a move up in US real yields to -45bps over the next 12 months would imply European outperformance of around 8% (based on data since 2018).”
In terms of sectors, they suggest Financials, Autos and Commodities, all of which have shown the highest positive correlation to US real yields since 2018, while defensives and Software are the most negatively correlated. That said “any decline in inflation break evens would suggest a more defensive rotation. We believe a similar pattern is likely to occur again this time if US real yields rise against a backdrop of stable or rising inflation expectations. However, if the latter were to decline persistently, history suggests we would see defensives outperform. We recommend that investors consider moves in real yields in the context of the growth/inflation outlook, and not in isolation.”
The rise of inflation indices
All this chatter around investment strategies has also prompted the inevitable emergence of custom indices designed to capture an inflationary surge.
First off the mark is SG again where the quant team have been building an Inflation Tracking Equity index which is now live.
This comprises a European and North America universe consisting of stocks with >$10m ADV and market cap >$1bn plus a minimum five years of history as well as UNGC and other policy exclusions applied. The SG report then selects stocks from the following sectors:
1) Basic Materials
2) Consumer Goods
4) Oil & Gas
This focused list is then analysed using monthly stock betas since 2002, using:
1) Metals prices (Copper)
2) Food prices (Corn)
3) Inflation expectations (US 5y5y)
The chart showing the changing index composition is below. In simple terms, be long miners.
Chart : SECTOR WEIGHTS WITHIN THE INFLATION PROXY INDEX
Scientific Beta has also jumped into this space and launched their own take on an inflation index – you can see more detail here : https://www.scientificbeta.com/factor/#/index/ADU-xxEI-xPx
According to Scientific Beta “the index’s positive exposure to inflation is obtained by overweighting (or underweighting) stocks relative to the broad cap-weighted index with high (low) exposure to changes in expected inflation in such a manner as to maintain a low level of tracking error and turnover as well as to conserve “cap-weighted like” characteristics such as the number of constituents, liquidity and investability.”
There are no details on the index constituents at the moment but we’ll be sure to check back in imminently.