Well respected analysts and market participants alike are behaving as if we’ve finally turned the corner on the worst financial calamity of this century, albeit barely getting underway. We are almost ten years post-crisis. Ergo, it may be time to reassess asset allocations. But, it could be a big mistake to merely extrapolate the cyclical trends of the past economic cycles. Some say that re-emergence from burst credit bubbles are different from cyclical recessions. If, as some believe, asset allocation is about finding market asymmetries—that is, areas where the consensus may be wrong and the cost of exposure is low, thus the investment opportunity is mispriced and tilted in your favor, then one such asymmetry is in those tame expectations for inflation. What if inflation exceeds those expectations? Perhaps economically sensitive equities are a way to benefit. Many are starting to look at dividend-paying companies and small to mid-size capitalized stocks to take advantage of high operating leverage to increasing growth and price trends. Many of these equities offering opportunity are appearing in overseas markets. But focus: what worked in the past may not work again in the future.
New secular drivers may be at play as new nations entering phases of rapid development. Shorter-term changes in politics and policy that marked the current era may beg for a reassessment of one’s portfolio. Many anticipate new policies to spur global growth are in stark contrast to previous policy driven influences such as Quantitative Easing and negative interest rates from 2008-2016. Analysts at Bloomberg expect real GDP plus inflation to improve to roughly 6% growth over the next two years as inflation and real growth increase. Deutsche Bank analysts think productivity is likely to decline. Well, if low-cost labor will no longer propel productivity and deflation globally, perhaps due to robots filling in every aspect of our economies globally, then one may investigate ways to benefit should inflation exceeds expectations. The natural place to investigate then, is China,manufacturer for the world. And, indeed the Chinese producer price inflation is back in positive territory for the first time since 2012.
So, if US long-term treasuries were the safe-haven for the 2008 deflationary cycle, Lord Abbett analysts suggest that “economically sensitive equities” are the place funds should flow out of bonds to benefit from a return of inflation. They like a focus on dividend-paying companies as dividends grow with inflation over the medium term. They also like small and mid-cap stocks as such tend to have high operating leverage to increasing growth and pricing trends.
They also suggest that assets positively correlated with inflation, negatively correlated with higher interest rates, and relatively low volatility may be another ideal hedge. But, Lord Abbett isn’t thinking of TIPS or commodities. Rather, a combination of inflation index forward contracts anda a short-maturity income fund would provide the best combination of those factors. So, if this strategy sounds appealing, then an inflation focused strategy may be a great approach.
Finally, a strong US dollar weakening, coupled with excessive pessimism caused by political turmoil in Europe and Asia could set the stage for another asymmetry to exploit. Recent economic indicators from overseas (China; Europe) have exceeded expectations and several leading indicators show a broadening of growth around the world, not a weakening. More than 90% of the world’s manufacturing purchasing manager indexes are above 50-showing they are in expansion.
If your portfolio is based on the trends of the past cycles, it may be time to reassess the new world dynamics and consider reallocation according to your risk appetite.
NOTE: Small-cap and mid-cap company stocks tend to be more volatile and can be less liquid than large-cap company stocks. Due to market volatility, the market may not perform in a similar manner in the future. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.
This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.