by Franklin J. Parker, CFA
The Summary
- Earnings season kicks off this week. Investors will be watching the figures and listening to forward guidance very closely. There are mixed signals on the recovery, and earnings season stands to offer some clarity on the ongoing economic recovery. The big banks start this week, including JPMorganChase, Bank of America, Goldman Sachs, and Wells Fargo. Alcoa, long considered a bellwether for manufacturing, also reports earnings this week. I am listening carefully for CEO commentary on inflation and the rising costs of their manufacturing inputs (like labor and materials).
- In addition to earnings, we get inflation data on Tuesday, producer prices on Wednesday (another inflation measure) along with The Fed’s Beige Book on Wednesday (the Fed’s assessment of the economy), industrial production figures on Thursday, and retail sales on Friday. Oh yes, and Fed Chair Powell testifies in front of Congress on Wednesday/Thursday. All-in, this could be a very important week for data!
- Last week was fairly quiet on data and financial news. The European Central Bank announced a shift in their inflation targeting policy. Similar to the change made by the US Federal Reserve a few years ago, the ECB will now target an average inflation figure, rather than a red-line inflation figure. ECB President Christine Legarde announced today that investors should expect updated policy guidance this week—almost certainly meaning ongoing/increased quantitative easing and low interest rates.
The Details
Stagflation is back?
Stagflation is an environment in which the economy is stagnant, but inflation is high. This tends to yield lower stock prices, high unemployment, and rising prices—a bad combination! These moments are rare in economic history, but the late 1970s to early 1980s are a vivid reminder of how bad things can be, and—at least up until now—the Federal Reserve has been keen to avoid even a whiff of catalyzing such an environment.
So far in this recovery, however, inflation and economic growth have been in keeping with their expected trends, however, with inflation posting considerably hotter than expected over the past few months and economic growth normalizing, investors have begun talking about a possible stagflation scenario. Admittedly, these are tough environments to navigate, and most of the veterans who managed money through the Volker years have long since retired. In other words, there is little institutional memory of the nuance to managing through such an environment. The worry is legitimate.
I am not yet convinced that stagflation is on the horizon. My current thesis is that we are going to be stuck in a long-term low growth/low inflation environment for the foreseeable future (not unlike Japan). Of course, my view will change as the data changes. That said, it is my job to think through possible investment scenarios and have contingencies for them. I never want to be scrambling to think through a strategy for an unforeseen economic environment.
Generally speaking, the stagflation investment plan goes something like this:
- Avoid long-dated US Treasury bonds. With inflation expectations changing often and quickly, investors will reprice US Treasuries constantly. This creates lots of volatility in the space. Furthermore, because equity investors are doing the same, bonds cease to offset stock losses. The same tends to be true for corporate bonds. Staying duration neutral is the best strategy in a stagflationary scenario. That insulates your portfolio from the volatility of interest rates while markets reprice inflation expectations.
- Stocks, generally, tend to perform poorly. With high unemployment, low wage growth, and higher costs, companies have difficulty producing profits in a stagflation environment. Of course, there are always some companies that perform well. Finding those companies and sectors that generate growth and continue higher is critical (I looked at the interest-rate sensitivity of various sectors to interest rate changes in a previous post).
- Commodities generally outperform. Tilting an investment portfolio to be overweight commodities (or commodity producers) may be a helpful way to gain growth exposure. That comes with a cost, of course, as commodities are considerably more volatile than stocks.
- Depending on the global picture, picking up higher international exposure may be worthwhile. Inflation is, at heart, a rapidly depreciating currency. So, by moving your cash into a foreign currency, you can make money as your home currency loses value. In essence, you buy a foreign investment with dollars that are more valuable today, then you sell the foreign investment and use the foreign currency to buy even more dollars in the future (because the foreign currency gained value relative to the dollar).
The point is, there is a way to approach any economic environment. And, while I do not yet see stagflation on the horizon, there is a playbook for it.
Chart of the Week
FactSet reports that the S&P 500 is expected to report year-over-year earnings growth of 64%—the largest growth in over 10 years. This week’s chart is from FactSet, and shows their bottom-up target price vs closing price for various sectors. In other words, this is how undervalued/overvalued, they see current sectors.
Energy is clearly favored, followed by materials and communication services. This should be little surprise as energy was decimated by the Covid recession, and materials have benefitted from both the recovery and the recent bout of inflation. Real Estate is most fairly valued, and this is again little surprise.
Of most surprise to me is their assessment of technology—expected by FactSet to underperform the S&P 500 as a whole. After powering through the recession with relative ease, and leading the recovery, investor views have shifted on technology. Of course, that isn’t to say that individual companies won’t outperform, but that the sector as a whole may be out of favor.
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