This Selloff Has Yielded Important Information Content

February 07, 2018
By Bryce Coward, CFA in Economy, Markets, Portfolio Management

This selloff is demonstrably different than other corrections the market has endured this cycle in one important aspect: it has inflationary rather than deflationary notes to it. This is an extremely important point of context because it tells us something about market participants’ anxieties. Specifically, it suggests that investors are more worried about an inflationary bust than a deflationary bust, a distinction that informs the asset classes most likely to outperform in the months and quarters ahead, as well as those assets that may act as the most effective hedges to downside volatility.

A brief review of deflationary and inflationary busts may be useful. A deflationary bust occurs when price levels fall, nominal economic growth falls and unemployment rises. It has been the dominant concern of central bankers and market participants since the late 1990s, and especially so since 2008. How do we know? Stock prices and interest rates have been highly positively correlated. That is, when stocks go up, interest rates rise and when stocks fall, interest rates decline. Interest rates fall in a deflationary bust scenario because both nominal growth and inflation expectations contract. Therefore, when a deflationary bust happens or its prospect is high, one wants to be long counter cyclical stocks (staples, health care, real estate, utilities, telecom) and one hedges that position with long-duration nominal treasury bonds.

An inflationary bust scenario occurs when price levels rise, real (inflation-adjusted) growth falls, and unemployment rises. It was the dominant concern of central bankers and market participants from the 1970s through the late 1990s, which we know because interest rates and stock prices were negatively correlated. When stocks went up, interest rates fell and when stocks went down, interest rates rose. Interest rates rise in an inflationary bust scenario because inflation expectations rise and the term premium (the compensation investors require for holding longer maturity bonds) rises. When the prospect of an inflationary bust is elevated, one should be long cyclical stocks that are able to pass price increases through to consumers and one hedges that position with commodities, such as gold or energy positions, inflation protected bonds, and cash.

So, why does the nature of this sell off suggest investors are most worried about an inflationary bust scenario? At least four reasons come to mind.

1) Interest rates have risen as stocks have fallen since the 1/26/2018 peak.

2) The less cyclical developed markets have barely outperformed the highly cyclical emerging markets since 1/26/2018. In a deflationary sell off, emerging market stocks will typically handily underperform developed market stocks.

3) Cyclical sectors have outperformed counter-cyclical sectors. Indeed, consumer discretionary and tech have each lost much less than everyone’s go-to safety sectors of staples and health care.

4) Commodities, which during a deflationary sell off will typically handily underperform stocks, have barely budged.

If these short-term relative movements persist (a big if indeed given the two decades of deflationary pressure we’ve endured), then investors may benefit from adjusting their allocations to a more foreign, cyclical exposure as well as considering employing hard assets as hedges to a possible inflationary outcome.

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