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CLS: Inflation, Higher Interest Rates, What’s on Sale?

02/24/2016

Week in Review
In a holiday-shortened week, the market continued to take its lead from oil prices. A strong equity rally began the week as oil prices rose above the psychologically significant $30/barrel level. The market peaked mid-week and went lower after a benign release of minutes from the Federal Open Market Committee (FOMC) Wednesday that essentially shut the door to an imminent rate hike. Even considerably stronger readings on Producer Price Index (PPI) and Consumer Price Index (CPI) data did not influence the general consensus that we’ll see no rate hikes in the very near future. However, there are some encouraging signs that inflation may have bottomed.

So, Let’s Talk Inflation
CPI data came out last Friday in an interesting report. In short, while inflation was unchanged from the prior month, it was clearly above market expectations.

Inflation is now up 1.4% over the last year. “Core” prices (goods excluding food and energy) were up 2.2%. Earnings, adjusted for inflation, were up 1.1%. These numbers are still lower than those most of us are used to seeing, but inflation is not down and out. Inflation is happening – and it is steadily moving higher.

Think about it. Gasoline prices dropped nearly 5% in January. These are the lowest levels since March 2009. And overall, prices still went up.

Here are some of the notable sub-data that up-ticked:

  • Core services +3.0% from +2.9% year-over-year (YOY)
  • Core goods -0.1% from -0.4%, the least negative in two years
  • Housing +2.10% from +2.07%
  • Primary rents +3.71% from +3.68%
  • The all-important “owners’ equivalent rent” (OER) +3.16% from +3.14%
  • Medical care +3.0% from +2.58% YOY
  • Medicinal drugs +2.21% from +1.66%
  • Professional services +2.08% from +1.92%
  • Hospital +4.32% from +3.96%
  • Bottom line, inflation is still a factor in the markets and will likely re-assert itself. In the words of Mike Ashton, an inflation analyst we follow at CLS:

“And all of this means that higher inflation remains in our future. The notion that deflation is some kind of existential threat makes as much sense as the notion that alien invasion represents an existential threat: possible, but not something that ought to keep us awake at night worrying. Inflation expectations do not drive inflation – it is the other way around. Inflation is headed higher, whether people – and the FOMC – expect it, or not.”

If inflation is indeed moving higher, what can we expect to see in the markets and how will CLS portfolios react? Specifically, how are we moving portfolios now?

  • The Federal Reserve (Fed) will likely keep raising short-term rates this year. This will make money market funds more attractive.
  • Longer-term rates are more likely to rise than fall (assuming the stock market doesn’t falter). Thus, we are keeping our portfolios with below-average duration (“interest-rate sensitivity”). In other words, if rates do rise, we shouldn’t slip as much as the bond market.
  • It will be easier for corporations to pay interest on bonds when interest rates are low and their business outlook is positive. As such, we have been buying corporate bonds, both investment-grade and high- yield.
  • Inflation-linked bonds, like TIPS, we are expecting outperform conventional nominal Treasury bonds. We have been buying these up.
  • The financial sector – the one that is beat up nearly as much as energy – has historically been one of the best to own when rates rise.

Financials Beaten-Up in a Good Way
Higher interest rates should benefit the troubled  financial sector, which has received a lot of negative press recently, especially from foreign banks. And they have been beaten-up badly.

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