Why it is too early to say the inflation trade is over

The Federal Reserve’s allegedly hawkish tilt at its June policy meeting and insistence that the current inflationary spike is ‘transitory’ is giving markets pause for thought and prompting more cautious investors to argue that the shift to cyclicals and ‘value’ stocks is over, says AJ Bell investment director Russ Mould.

But it may still be too early for those in the deflation camp to declare a knock-out victory just yet.

Granted, there are good reasons for proclaiming inflation is just the result of a base effect, pent-up demand as lock-downs ease and supply-chain disruption. Deflation – or at least the disinflationary trend of the last four decades – could yet reassert itself, thanks to the globe’s massive (and growing) debts, the price-crushing transparency and power of the internet and trends in automation that could keep a lid on wages.

Yet the classic stages of an inflationary cycle do seem to be falling into place – increases in commodity prices, then factory gate prices, then consumer prices and finally wages. Pay inflation in the US is now running at over 5% on an annualised basis. If that becomes entrenched, and consumers become accustomed to paying higher prices and getting salary enhancements that match them, then inflation could be off to the races.

This has huge implications not just for the value of consumers’ money – as its purchasing power will go down as fast as inflation remains above interest rates – but their investment portfolio too. It is still possible to argue that we are on the cusp of a major shift in markets, from paper to real assets and within stock markets from long-duration, secular growth plays to cyclical, value names.

The Bloomberg Commodities index has already gently outperformed the FTSE All-World equity benchmark for a year (if the line goes up, commodities are outperforming equities and if the line goes down the paper assets are outperforming real ones). But commodities underperformed for the whole of the past decade having massively outperformed during 2000-10 as oil and metal prices soared (and growth stocks fell from favour amid the collapse of the tech, media and telecoms bubble).

This is why some strategists are asking the question as to whether a rise in inflation could represent a generational tipping point, from an investment point of view:

Source: Refinitiv data

The cyclical versus secular growth trade – or value versus growth for want of a better turn of phrase – is losing a little momentum after a good run, but again it feels too early to say it is game over. This can be measured quickly by checking the performance of the iShares Russell 2000 Value ETF (ticker IWN:NYSE) and the Invesco QQQ Trust (QQQ:NYSE).

The Invesco QQQ Trust is designed to track the performance of the NASDAQ Composite’s index’s largest 100 non-financial companies and deliver that performance to investors, minus its running costs. The QQQ has $175 billion in assets under administration and its biggest holdings are Apple, Microsoft, Amazon, Alphabet, Tesla, Facebook and NVIDIA. It is therefore a good proxy for ‘growth’ and those firms whose business models have thrived during the pandemic.

In the opposite corner we have the iShares Russell 2000 Value ETF. It has $16.3 billion of assets under management and follows a basket of nearly 1,400 stocks that offer ‘value’ characteristics. Sixty percent of the portfolio lies in the financials, industrials, consumer discretionary and real estate sectors – against barely 25% in the QQQ – and it has just 5% in technology, against 63% in the QQQ.

If the line is pointing up, value (IWN) is outperforming growth (QQQ) and vice-versa.

Source: Refinitiv data

Investors’ view that the Federal Reserve is becoming more hawkish seems surprising when the US central bank is planning just two one-quarter point rate hikes from a record low of 0.25% over the next two years – hardly a dramatic swoop and more the tentative chirp of a budgerigar.

If the Fed is right, then long-duration, ‘jam tomorrow’ assets such as tech and biotech stocks and unicorns, as well as long-dated bonds, could maintain their strong performance of the past decade. If it is wrong and the recovery is robust and inflation becomes entrenched then short-duration, ‘jam today’ cyclical, recovery sectors and commodities could thrive, along with companies that have pricing power or any revenues that are index-linked.

The Fed continues to describe the current spike in inflation as ‘transitory,’ in the view it is caused by pent-up demand as lockdowns ease and supply chain dislocation, both factors they view as temporary. But central banks in Brazil, Mexico and Russia are already raising interest rates and citing inflation as the reason why – they clearly think it may not be temporary, so the debate continues to rage.

These articles are for information purposes only and are not a personal recommendation or advice.