Stagflation Portfolio Luring Managers Who Say Time to Act Is Now
(Bloomberg) -- Most investors have come to terms with inflation, viewing it as evidence of an expanding economy. But not everyone. An increasingly vocal minority is sounding off about their vision of rising costs, falling employment and slow growth, the chilling combination known as stagflation.
Jerry Braakman, for one, isn’t waiting to see how it plays out and is bracing for just such an environment. The chief investment officer of First American Trust has been piling on exposure to real estate investment trusts and technology and offloading financials, which should theoretically be weighed down by a flattening yield curve.
Stagflation tends to be a touchy topic in financial circles, since it evokes soaring oil prices and sky-high unemployment rates. While the current macroeconomic landscape is dramatically different from the 1970s, certain similarities have emerged: transitory inflation is proving hotter and more persistent than expected, real economic growth is cooling and millions of workers remain sidelined.
Economists can debate whether the “stagflation” label is hyperbolic or prescient, but with inflation expectations lingering near decade-plus highs and the global growth outlook darkening, Braakman began reshuffling his portfolio in June.
“We’re going to have a decelerating, still-growing economy and inflation is going to stick around,” said Braakman, whose firm manages $2 billion. “So we get into that stagflation.” In that scenario, REITs and technology still tend to do well and gold starts to look attractive, he said.
The notion that we’re in a stagflationary environment -- or that one is around the corner -- is still a peripheral view at the moment, with GDP growth in the U.S. expected to top 6% for the year and consumer confidence improving. On Wall Street, corporate earnings remain strong, with the latest earnings season seeing profits double from year-ago levels.
One explanation for the differing outlooks is that not all inflationary periods are equal. Chun Wang at the Leuthold Group says some price increases are driven by what he calls “demand pull,” which is often accompanied by lower unemployment rates, while others are from “cost push,” marked by things like higher commodities prices.
Wang says the current inflationary span is being driven by demand pull, where stocks tend to perform well within more favorable economic settings. In contrast, cost-push periods make for “lackluster” returns and tend to coincide with stagflation.
Those who say that we’re in a stagflationary environment are finding evidence of it everywhere. June’s annualized consumer-price index jumped 5.4% versus a year earlier, the hottest pace since 2008, and July’s reading, released Wednesday, remained at that level. However, wages haven’t kept up: Year-over-year average hourly earnings growth accelerated 4% in July.
This mismatch -- Americans paying more for goods while their paychecks lag -- could be one of many factors dragging on real gross domestic product. The inflation-adjusted figure clocked in at 6.5% in the second quarter, well below forecasts of 8.4%.
Against a backdrop of a U.S. labor market where there are more and more jobs openings but the participation rate remains depressed, the specter of stagflation, in the eyes of some, is materializing in markets. Rates on 10-year Treasury yields dropped to 1.12% last week, weighed down by a drop in so-called real yields -- which strip out the effects of inflation -- to an all-time low, suggesting traders see little growth ahead.
Supply crunches are boosting prices on big-ticket items such as houses and used cars, which is in turn crimping spending as consumers suffer sticker shock, according to Peter Boockvar, chief investment officer for Bleakley Advisory Group.
Such a stagflationary environment should benefit sectors with the highest degree of pricing power -- “energy, materials, even some consumer durables, if they can pass on higher costs to consumers, which they’re trying to,” Boockvar said. “P/E multiples would likely compress if this becomes sustainable and thus highly valued stocks would be most vulnerable and cheaper ones less so.”
With benchmark Treasury yields falling as low as 1.12% last week, investors are clearly pricing in some degree of stagflationary risk, BMO Capital Markets’ Ian Lyngen said. But unlike the full-blown stagflation seen in the 1970s, the current dynamic doesn’t stem from an external supply shock and unions no longer have the collective bargaining power to push wages higher -- meaning that should real growth rebound, the situation should resolve itself, the rates strategist added.
“This is a clear sign that it’s a potential risk,” Lyngen said. “However, if employment continues to improve and wages catch up, then real growth will also gain.”
Quadratic Capital Management’s Nancy Davis doesn’t see such an easy fix. While the oil market was the epicenter of the 1970s stagflation experience, it’s possible that higher labor costs or the ongoing semiconductor shortage could be the culprit in today’s economy.
“In a stagflationary environment, we would expect equities and bonds both to come under pressure. As investors sell across asset classes, correlations would increase,” Davis, manager of the $3.2 billion Quadratic Interest Rate Volatility and Inflation Hedge ETF, said in an email. “Stagflation is the traditional 60/40 portfolio’s worst nightmare.”
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