There’s a general playbook for investing when it comes to the macro-economic business cycle. The cycle includes four stages: Reflation, Recovery, Overheat and Stagflation. You might also hear other terms used to describe each stage but we’ll run with these because Merrill Lynch made this nice chart for us.
Within each stage, investment assets tend to perform differently, and the bulk of your returns are determined by asset allocation, so determining which stage we’re in is a key step to portfolio positioning. I was starting to suspect that we were close to moving from stage II “Recovery” to stage III “Overheat” and this week confirmed it for me. The key to this stage is that supply constraints start to hit which forces up prices/inflation and we get a final boost in economic growth until higher prices start to choke off spending. For example, if you’re spending more on healthcare and energy costs, you have less available for discretionary spending. This is why most recessions are preceded by a large rise in oil prices.
Here’s why we’re likely to see inflation start to surprise to the upside:
- The labor market is the tightest it’s been during the recovery so we’re (finally) likely to see decent wage growth.
- The US dollar is down about 10% YoY which makes imports more expensive.
- President Trump is beating the drum on tariffs, which makes imports more expensive and tends to lift commodity prices.
- Commodity prices have been falling for 3-5 years (depending on the commodity) so production has been falling. This leads to lower supply and ultimately higher prices.
- Housing, rents and healthcare costs continue to rise at very high rates.
Inflation always lags other economic data by a few months and the market tends to wait for confirmation, but once it believes it interest rates tend to rise and yield sensitive assets (i.e. bonds, REITs, Utilities, etc.) come under pressure. High growth stocks still do OK but start to lag cyclicals and commodity based stocks. The price action all month in the commodity and industrial related stocks has been very strong and bonds/REITs/Utilities are starting to look like they’re rolling over. The big tech and consumer discretionary companies that have led most of the rally are also starting to lag.
Performance over the last month, from top to bottom: Energy, Materials, Industrials, Consumer Discretionary, Tech, Bonds, Utilities
Commodities are probably the most hated asset class right now. Below is a chart of commodity prices relative to the Dow Jones Industrial Average (stocks). As you can see, commodities are dirt cheap and offer a lot more value than just about every other asset class. Stocks on the other hand, relative to commodities, are looking as expensive as they did in 1929, 1970 and 2000 – all of which preceded a decade of very low returns for stocks on average. This is something I’ve been talking about for 2 years now. QE lifted stock prices more than they would have climbed on their own and effectively pulled forward future returns.
This stage tends to last about a year or two, but that can vary, all depending on how aggressively the Fed raises interest rates to stifle inflation. Regardless, it tends to be much shorter than the Recovery phase and you do not want to own most cyclical stocks through the full cycle so I’ll primarily be adjusting exposure via stock options on individual names or sector ETF’s that look poised to rally. Longer term, we’re still facing the deflationary pressures of high debt and aging demographics so I expect yields to remain relatively low for years. If we continue to see this shorter-term cyclical push higher in yields knock down sectors like Utilities and REITs, it will be a very nice long-term buying opportunity in both.
Thanks for following and have a great weekend!
-Nick