Written by Lance Roberts, Clarity Financial
This continues from Trending In The Wrong Direction.
The trade du jour has been to buy stocks that benefit the most from inflation. Energy and materials have been the hottest sectors over the last few weeks, and bitcoin is on fire. Conversely, utilities and REITs have suffered as higher interest rates tend to accompany inflationary expectations.
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As such, the graph below is essential for stock investors to follow. Yes, we know it is TIP bonds, but it accurately quantifies the inflationary sentiment driving stocks.
The graph compares 2-year, and 10-year implied inflation levels. By comparing TIP yields to nominal Treasury yields, we extract the breakeven, or implied, inflation rate that makes investors indifferent between the two securities. As shown, short term expectations have risen from nearly -1% in April to 2.25% today. Short term expectations are at the highest level since 2013. 10-year inflation expectations are less volatile but have risen sharply.
The genius of the graph is the interaction of inflation expectations to the spread between the two. Short term inflation expectations tend to be lower than long term expectations. However, when they reach or exceed long-term expectations, they tend to peak and reverse sharply. The dotted lines highlight the seven times in the last 12 years this has occurred.
The bulls argue this time is different and inflation is a real threat, unlike the past. The bears rely on the past relationship and forecast a rapid decline in inflation expectations.
The eagles, ourselves included, have the luxury of watching the data and adjusting our stance as we see how the two rates react to the curve inversion.
Portfolio Positioning Update
With January kicking off with a bang, we are maintaining our long bias with reduced hedges at the moment.
We made some changes to align our portfolio more with our equal-weighted benchmark index during the past week by reducing some of our overweight in technology, healthcare, and communications. While many other sectors of the market are grossly overbought short-term, we added a 5% weighting of RSP (S&P Equal Weight ETF) and SPY (S&P Market Weight) to our portfolios for the time being as placeholders.
We are currently slightly overweight equities and underweight our hedges in fixed income as interest rates press higher.
As noted last week, the rally this week was not unexpected:
“With the stimulus bill passed, and checks going out, we won’t be surprised to see a short-term pop in economic activity. However, given the checks are 50% smaller than the first round, along with extended unemployment benefits, the economic bump will be short-lived. The real question going into 2021 is whether President Biden can spend further into debt to do more stimulus. Or, will a shift toward fiscal responsibility begin to take hold? Much will depend on the Senate run-off outcome in Georgia.
Regardless, the evidence is mounting that economic and earnings data will likely disappoint overly optimistic projections currently. Furthermore, investors are way too confident. Historically, such has always turned out to be a poor mix for a continued bull market advance in the short-term.
Even with the Senate now a 50/50 split, more moderate Democrats may start to balk at massive increases in debt. There may also be some pushback against some of the more far-left socialistic policies as well.
We will have to wait and see.
For now, we will continue to trade accordingly.
This is the third article in a series of 3. The previous articles:
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