Rising Inflation Expectations Drive Investors Out Of Risk Assets!

 By Mitchell Anthony

July 8, 2022

While inflation has been running hot for over 1 ½ years, investors and the central bank have not believed that the inflation was entrenched and hence inflation expectations stayed relatively low until recently.  Over the last 3 to 4 months that position has changed significantly and as a result investors hit the sell button in a dramatic manner last quarter. Risk assets of all types had double digit losses in Q2.  Stocks, REITs, Treasuries, Corporate Bonds, Junk Bonds, and Commodities all swooned with the worst losses occurring in high PE stocks and real estate investment trusts. Both of these were down 25 to 30% in Q2.  MACM’s dynamic growth portfolio lost over 16% despite a double digit cash position.  Clearly we have a new hawkish position from the Fed that combined with investors armed with knowledge of how stocks and risk assets perform during periods of high inflation, combined to drive investors out of risk assets and into cash.  Even ultrashort term bond funds lost money in Q2!

The Fed’s new resolve to kill inflation all but ensure that a recession will take place this year and maybe into 2023. The uncertainty of what a recession might do to the current themes of consumption in the globe has caused extreme volatility in risk assets.  The US economy has been driven by four strong consumption themes for the last several years.  These themes include: housing and related durable goods, the buildout of cloud computing infrastructure, consumers desire to convert to electric vehicles, and consumers pent up demand for experiences.  The sustainability of these mostly secular growth themes has now been questioned by investors and will continue to be questioned until more visibility is available causing further volatility in risk markets.

Almost all risk assets have had a severe decline! Cash alternatives also got hit.

In the second quarter US stocks were down 15 to 25% depending upon the index, emerging markets declined by over 11% (EEM).  REITs fell 15 to 30% depending upon the type of property with malls and office buildings being hit the hardest and single-family homes performing the best of the worst.

US treasuries fell 5 to 15% depending upon the maturity. Corporate bonds as measured by (LQD) fell over 9% along with their junk bond counterpart declining near 11% (hyg). Ultrashort term bonds which hardly ever lose ground, declined a bit as short-term rates rose dramatically. (MINT-1%, JPST -.4%).

Believe it or not the worst returns in Q2 were in the commodity marketplace as traders now believe the Fed will ultimately be successful at killing inflation. As a result lumber fell 28%, copper fell 22%, and steel fell over 40%.  Most food commodities were flat with some a bit higher and some a bit lower.  Wheat and corn declined the most.   Oil remains steady gaining over 5% in the quarter as producers were nimble at matching production with demand.

Global Economic Trends Mostly Similar To US Trends.

The global economy is mostly in an economic downturn and has similar trends to America. The economic impact from the pandemic seems mostly minimal now.  Trends in China are still very hard to understand or explain. China’s response to Covid was mostly negative as they shut down their economy and did very little from the fiscal perspective to prop up consumers or stimulate their economy as the pandemic storm subsided. As a result there markets crashed but now seem to be stabilizing but at the lowest valuations in decades.

US Trends Are Almost All Negative In Some Manner!

  • Continued high Inflation CPI 8.6% all quarter, PPI – 16.7%, PCE 5.2% – 4.6%
    • Core Inflation is rolling over in both CPI and PCE but Food and energy are keeping it hot.
    • Rising inflation expectations are notable. Breakeven (TIPS – Treasury) show a decline in inflation expectation of over 100 bips
  • Food and energy are sticky – related to war.
  • Prices of Durable goods are mostly rolling over? Finished goods are not!
  • Rising interest rates – treasuries, mortgage, CC’s all saw significantly higher rates in Q2.
  • Strong trends in Employment Remain although the size of our employment pool has declined.

The US economy continues to have strong consumption despite falling confidence. Consumer Confidence is now near its pandemic low.  There’s clearly been trouble in the world of retail.  E-commerce giant Amazon over-expanded their warehouses and employees during the pandemic which created expensive excess capacity that more than killed almost all of 2021’s earnings.  Big box stores like Target made substantial mistakes by extrapolating out pandemic consumption into the future and over ordering inventory.  As a result they are awash with televisions and other durable goods that they are having to sell at discounts or losses.  The previously strong world of experiences is now a bit uncertain.  It would seem that dining out is less attractive given the higher prices and the decreased wealth of consumers. This seems to go hand-in-hand with other forms of entertainment.  The substantially higher interest rate environment has or is in the process of hitting housing and related durable goods. Sales are down although prices have tried to hold past levels but seemed destined to crumble as deceleration or declining demand hits.  The industrial sector is still running strong based upon its inability to meet the demand we had through most of 2021. The production of Autos and other durable goods are playing catch-up even while current demand is in decline. We are seeing weakness in factory equipment and automation stocks like Rockwell and Ingersoll-Rand leading us to believe that orders their have weakened considerably.

The Economic and Market Outlook

Inflation will undoubtedly set the tone for both growth in the Global economy and the performance of Risk assets. Inflation has been difficult to forecast as we haven’t had a real inflation cycle since the 70s to live through and experience.  Given that it seems reasonable to err on the side of forecasting that inflation will last longer than is reasonable to expect.  The risk is that markets will undoubtedly take off to the upside as we get hints that inflation is subsiding.  Right now the reality is that food and energy prices are still high and are being led higher by fertilizer and other related products for crop production.  The good news is that durable goods seem positioned for disinflation or deflation as there is evidence in a notable decline in durable spending on household equipment.

We believe risk assets are unlikely to bounce significantly until inflation has begun to confidently trend back toward 2 to 3%. The timeframe for this is unknown but likely to be more than six months and may be as long as two years.  The best-performing asset classes for the next six months will likely be ultrashort term bonds as risk assets ebb and flow as we work through the unknowns of inflation.  MACM DG portfolios have 20% or more in ultra-short term bond ETF’s.  Beyond that we see investors returning to equities that are positioned well for the consumption themes that will likely remain intact through this recession.  Speculation will clearly ebb and flow and bring about rallies in risk assets as we await the death of hyper-inflation.

We are optimistic that risk assets will return front and center and we will be positioned to leverage the great returns in those areas as they occur.