Opportunities In A Treacherous Macro Environment

Key data on U.S. inflation couldn’t have come at a better time for attendees of the Exchange conference in Miami Beach, Florida.  

The macroeconomic panel, featuring Michael Arone, chief investment strategist for SPDR at State Street Global Advisors, and Emily Roland, co-chief investment strategist for John Hancock Investment Management, began with a discussion on inflation and interest rates. Just hours before, the Bureau of Labor Statistics had reported that consumer prices in the U.S. surged 8.5% year over year in March, the fastest pace in more than 40 years.  

According to Roland, as unsettling as that number is, it probably marks the peak of inflation this cycle:  

“Our expectation was that this month probably would mark the peak. We just had the biggest mismatch between supply and demand that we will probably ever see in our lifetimes during the height of the pandemic.”  

“On the supply side, companies shed all of their inventories, they fired all of their workers, and then they tried to hire them back and restock their inventories, all at the same time. [On top of that], we sprinkled on all of these disincentives for people to return to the workforce.”  

“And then on the [other] side, demand exploded. We all looked around our homes and decided that we needed to redecorate. We bought furniture; we bought trampolines. Then, once the economy reopened, we reengaged in services; we went out again.” 
 
Roland said that all of the supply and demand factors that led to high inflation are starting to reverse course:  
 
“We’re already seeing some of these shipping issues get resolved. Of course, they’ve been exacerbated by the challenges of the zero-COVID policy of China—that’s created some inflation that’s lasted longer than we’ve expected—but those issues are being solved. Companies double ordered during the pandemic, and now inventories are above prepandemic levels.” 

“On the demand side, how many times can we all redecorate our houses? How many used cars can we buy? In fact, we are already seeing used car prices starting to come down, and that of course was a big component of inflation during the last couple of years. We also don’t have stimulus checks anymore.” 

“So, we are seeing supply side issues come off the boil, new orders come off the boil, and the demand side is cooling a bit. We see inflation coming down from here.”  

State Street’s Arone was largely in agreement that inflation is in the process of peaking, but he warned that price pressures could remain elevated for the foreseeable future.  

“We also anticipated that inflation would peak in the first half of the year as those supply chains cleared and we got some equilibrium between supply and demand. With that said, there are two risks to that call. The Ukraine conflict is certainly causing some issues with supply chains and price increases across food, metals and everything physical.”  
 
“China’s zero-COVID policy has also caused issues with respect to supply chains. Those two items are risks to inflation. In our opinion, inflation will be much more protracted in terms of its elevation. Inflation is going to remain much higher than the Fed would like. Whether it’s 8% or 4%, expect inflation to stick around.” 

Outlook For Rates  

Both panelists were in agreement that inflation was likely peaking, which would give the Fed room to back off its aggressively hawkish monetary policy stance down the line, putting a ceiling on where interest rates could go.  

“The market is pricing in nine rate hikes as of this morning; we are taking the under on that,” said Roland.  
 
“We are looking at an environment that is so unusual. [Historically], every time the Fed has hiked, it was into an accelerating growth backdrop. But this time, economic growth is decelerating off the peak of a year ago.”  

“Though we are doing fine [in terms of economic growth], the pace of economic growth is falling from its peak and the Fed is hiking. That’s why the yield curve is as flat as a pancake; it’s the bond market telling you that the Fed is going too far and too fast with their forward guidance. The Fed is watching that and they will have the opportunity to pump on the brakes as opposed to slamming on them.”  

Meanwhile, Arone remarked that where the Fed ultimately set its benchmark federal funds rate was less important to markets than what it did with its balance sheet. 

“Whether it’s eight, nine or 10 hikes, whether the terminal rate is 2.5% or 2.25% doesn’t matter. I think what the market is most concerned with is what they are going to do about the balance sheet. They’re going to start [rolling assets off their balance sheet] in May; how aggressively are they going to go? We have some targets now—$95 billion/month to start. But what will the impact be on asset prices once they start reducing it?” 

“We are in tightening mode until something breaks. So, the question is, is growth going to break first, or is inflation going to break first? When we see these bouts of volatility, the market is concerned that economic growth is going to break first. The balance sheet poses the biggest potential driver of volatility in markets at this point.” 

The strategist added that how the Fed responds to any market dislocations will determine whether the ”Fed put” still exists:  
 
“Even at the $95 billion/month rate of [unwinding the balance sheet], it’s going to take years to make a dent on it. And as soon as something [bad] happens, we’ll see if the Fed put still exists or not.” 

Arone predicted that the Fed put was still very much in play, just as it has been for decades.  

Changing Paradigm  

Inflation at such high levels is something that investors of this generation have never had to deal with. The significance of that can’t be understated, according to Arone.  

Additionally, he argues, there are other major challenges that investors still haven’t adjusted their portfolios to account for.  

“Throughout my whole career, interest rates have been low and falling; inflation has been benign. For the last 10 years prior to the pandemic, inflation has averaged less than 2% per year; we’ve had a peace-time dividend amongst the nuclear-armed world powers; we’ve had globalization trends. Those things are changing,” Arone said.  

Instead, now investors have to contend with a rising rate environment, higher inflation, deglobalization and questions about the peace-time dividend. In his view, portfolios are not positioned for that; they are still positioned for the old regime.  

What investors should be doing, according to Arone, is looking to higher quality, shorter-duration investments, both in stocks and bonds. He suggested investors look at dividend stocks and to invest in things that will benefit from rising prices, such as gold.  

He also said to look for companies with low labor costs, such as those in the energy and materials sectors. “You also want your cash flows sooner,” Arone added. “I want dividends, I want stable earnings. Companies that don’t earn any money and whose cash flows are far on the horizon are likely to continue to suffer.”  

Roland concurred that things “will be a little bit trickier from here” for investors. But she said stocks are still the place to be, as they’ve historically been the best hedge against inflation. In particular, she recommended U.S. midcap equities for inflation protection:  
 
“Midcaps tend to [comprise] companies that have a lot of operating leverage. When prices become elevated, those fixed costs—there’s not a lot additional investment in that—but those higher prices can be passed on to the end consumer, resulting in higher margins.” 

“You want quality stocks that have great balance sheets, good organic growth drivers and great earnings stability. Frankly, we’re finding a lot of that in technology and communication services. [We’re avoiding] unprofitable growth stocks, momentum and deep value.” 

Bonds Starting To Look Interesting  

Rising rates obviously have repercussions for more than just stocks. Bonds have been getting hammered amid the Fed’s hawkish pivot, with the Barclays U.S. Aggregate Bond Index just having put in its worst quarterly performance since the 1980s. Yet within the bloodbath may lie opportunity, said the panelists.  

Arone explained: “We know that rates are rising and inflation is elevated—those are threats to bonds. But we still have to use bonds for diversification, preservation and income. We think TIPS provide an interesting opportunity in a diversified fixed income portfolio as a conservative core option in an elevated inflation environment. On their own, the yields on TIPS aren’t great and they’re kind of expensive, but given your choices in other conservative fixed income sectors, they are kind of the best house in a bad neighborhood.” 

Roland disagreed: “TIPs are pricing in massive inflation expectations and, in our view, you don’t buy flood insurance when the flood is already in.” 

But TIPS aside, she said bonds in general were getting more attractive: “You’re getting 3.2% yield on the aggregate bond index; it’s getting kind of juicy. We just had the worst quarter for the AGG since Q1 of 1980, so it’s been a bloodbath for fixed income investors. Investors tend to hate bonds right before they love them. And we see investors selling bonds like crazy right now; there’s capitulation.” 
 
“We’re starting to see this backup in bond yields as attractive relative to history. If you subscribe to our view that the economy is decelerating and that recession is a possibility in 2023, you can’t have it both ways. You have to like duration, you have to want to own Treasurys. We’re not there, but in the quarters to come, we will be looking to increase duration, not shorten it.” 

Emerging Markets  

The panel closed out with a question from an audience member on emerging markets. Roland and Arone both emphasized China’s importance when it came to the space.  

“So goes China, so goes emerging market equities broadly,” said Roland. “We have a neutral stance on emerging market equities. The challenge with being underweight EM equities is that Chinese policymakers have a long history of stimulating when things go bad.”  

“We are overweight emerging markets. Relative valuations remain attractive, and GDP growth rates are still faster than in the developed world,” said Arone. We anticipate that China’s ambition is to continue to be the world’s economic power, the world’s financial power, the world’s military power and the world’s technology power. As a result, there is only so far that they can push common prosperity [and the crackdown on the country’s biggest firms]. You can pick up those stocks at 30% discount to where they were a year ago.” 

Arone said that one interesting way to invest in emerging markets is through small caps. As a result of the evolution of the MSCI Emerging Markets Index, there is no exposure to small caps:  
 
“If you look at historical returns, EM small caps are actually less volatile than the broader emerging market space and less volatile than domestic small cap stocks.” 

“If you have $100 invested in emerging markets, you might consider taking $25 or $30 of that and putting it in EM small caps.”  

Follow Sumit Roy on Twitter @sumitroy2