The strength of U.S. inflation pressures indicates a late-cycle environment for equities and this has profound implications for portfolio strategy.
Richard Bernstein, former Merrill Lynch strategist and founder of RB Advisors, notes that the market sectors that perform in late-cycle markets are much different than early-cycle winners: "Early-cycle sectors tend to be very credit-sensitive (housing, autos and retailing) … Cyclical sectors [now] make up the bulk of our equity positioning: technology, financials, materials and emerging markets. We remain very short duration within our fixed-income portfolios to help protect against rising long-term interest rates." (Shorter duration bonds tend to experience lower price volatility than longer duration bonds.)
Few Canadians are prepared for the typical late-cycle market backdrop consisting of underperforming bond portfolios (and by extension dividend and income stocks), and weaker housing prices. I should add, however, that most domestic investors are exposed to commodity sectors that tend to outperform as the cycle peaks.
The stronger-than-expected U.S. consumer price index result reported Wednesday supports the idea of higher inflation but there have been a number of false starts for inflation pressure over the past decade. The accompanying chart will allow investors to assess whether it's truly time to reposition their portfolios for a new market regime.
The chart compares the U.S. 10-year bond yield with the Vanda Cyclicals-Defensives U.S. Index. The latter measures the relative performance of economically sensitive markets sectors, such as materials and industrials, which outperform as inflation climbs, and defensive market sectors, such as consumer staples, which benefit from low interest rates and slower economic growth.
Both lines have been generally rising since September of 2017 and this is indicative of a faster-growth, higher inflation late-cycle market. The climbing purple line shows that economically sensitive stocks have been outperforming their more defensive counterparts. The rising 10-year bond yield shows much the same thing – growth is strong and inflation pressure is building.
The most important segment of the chart is the flatness of the Cyclicals-Defensives Index for the past month. Finance media have produced a steady stream of "equity investors run in terror from rising interest rates and inflation pressure" stories in the past 30 days. Yet, the flat line shows that the cyclical, economically sensitive late-cycle stocks that usually benefit from those conditions have not been outperforming.
The benign explanation for this apparent discrepancy is that cyclical stocks are merely pausing after a strong rally. It might also be the case, however, that equity investors are losing faith in the sustainability of inflation and economic growth, and they're worried about another slowdown and a decline in rates and bond yields.
In terms of the short-term market outlook, I can't think of another chart more important for global and domestic investors right now. The higher the lines climb, the more probable strong performance from resources and cyclical stocks becomes. That trend is also likely to cause some pain for bonds as well as dividend and other income-generating stocks.
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