Investors have been eyeing the threat of rising inflation. Fortunately, there’s a playbook for higher inflation.
Inflation expectations have risen robustly in the past several months. According to data from the St. Louis Federal Reserve, investors currently expect inflation to run at above 2% for the next 10 years. With inflation expectations up, the 10-year Treasury yield has risen to 1.37% from 0.67% since Sept. 23, the beginning of a rally in riskier assets that benefit from a strengthening economy. Expectations for trillions of dollars of fiscal stimulus and further economic reopening spurred by the vaccine rollout are driving the market movements.
The higher inflation forecast is causing some anxiety for stock investors, though. Momentary spikes in long-term Treasury yields pressure equity valuations A higher risk-free rate of return makes stocks less attractive. But inflation often reflects strong economic demand, which provides a major boost to near-term earnings.
If the economy begins a fresh expansion, these dynamics favor cyclical and more economically-sensitive stocks. Financials, energy and industrial sectors would benefit the most. For banks, loans are more profitable when long-term rates are higher. Demand for oil and other energy sources increases during expansionary times because manufacturers and consumers consumer more during these times. Industrials typically increase production to supply projects tied to business and consumer spending during times of expansion.
According to data from Evercore strategists, the financial sector sees the highest degree of outperformance against the S&P 500 when long-term yields rise. The energy sector is the second-best performer and industrials are the third-best. The sectors least correlated with higher interest rates are defensive ones, or those which have revenues and earnings that are less influenced by economic demand. Utilities and consumer staples, for example, don’t perform as well during inflationary times.
Indeed, the SPDR S&P Bank ETF (ticker: KBE) is up 71% since Sept. 23, trouncing the S&P 500’s 21% gain. Mid-September marks the beginning of a fresh rally in riskier assets like stocks and move higher in inflation expectation. The Energy Select Sector SPDR ETF (XLE) is up 53% since then, with the Industrial Select Sector SPDR ETF (XLI) exhibiting a move in-line with the broader index. Four of the top 10 holdings in the industrials fund— Honeywell (HON), Raytheon Technologies (RTX), Lockheed Martin (LMT) and 3M (MMM)—have heavy exposure to the rather defensive areas of aerospace and defense and medical products, which may weigh on the fund’s performance. But the highly cyclical industrial stock Boeing (BA), for example, has beaten the S&P 500 by nearly twice as much since mid-September.
Analysts expect stocks in all of these sectors to see continued earnings momentum through 2022. But industrials and energy stocks trade at substantial valuation premiums to the S&P 500, according to FactSet data. Smaller capitalization value stocks aren’t trading at those exorbitant valuations and might be a better way to play the inflation trade.
Write to Jacob Sonenshine at firstname.lastname@example.org