Understanding inflation is crucial for proper portfolio construction, especially for investors with exposure to 60-40 portfolios.
The current economic cycle is compressed, influenced by the Fed's response to crises, resulting in shorter but more powerful and erratic policy cycles.
In a mid to late cycle environment, asset allocation strategies must consider factors such as rising bond yields, evolving earnings growth, and inflation expectations.
Deep dives
Importance of Inflation for Investment Landscape
Understanding inflation is crucial for investors to make informed decisions and navigate the investment landscape. In periods of low but positive inflation, the bond side of a 60-40 portfolio tends to be negatively correlated with the equity side. However, during periods of above-average inflation, the correlation is historically positive. This is relevant for investors who have exposure to 60-40 portfolios, as getting the inflation part right is paramount for proper portfolio construction.
The Compressed Economic Cycle and Fed Policy
The current economic cycle exhibits characteristics of a compressed cycle, influenced by the Fed's response to crises. The Fed's monetary policy plays a critical role in shaping these cycles. In the past, the Fed has gone above and beyond neutral rates during tightening cycles. However, the duration of each cycle is shorter due to the more powerful and erratic policy responses. The challenge for the Fed lies in finding the balance between preventing excessive inflation and avoiding a detrimental impact on economic expansion.
The Impact of Monetary Tightening on Asset Allocation
In a mid to late cycle environment, asset allocation strategies tend to shift. Historically, late cycle periods see inflationary pressures, Fed tightening, and slower growth. Equities may still perform well, but not as strongly as during mid-cycle periods. However, the current economic cycle presents unique challenges, with the Fed tightening policy rapidly and supply chain disruptions causing market disruptions. Asset allocation strategies need to adapt accordingly, considering factors such as rising bond yields, evolving earnings growth, and inflation expectations.
Secular bull market in commodities
The speaker believes that we are currently in a secular bull market for commodities. While there may be cyclical boom-bust cycles within this trend, the overall trajectory suggests a long-term upward movement. However, the speaker warns against overstaying one's welcome in commodities as they can quickly give back gains. Despite the challenges of investing in commodities, there are certain regimes where they can perform well, and the current market seems to be one of them.
Gold as an inflation hedge
In the discussion about gold, the speaker emphasizes its role as a proven hedge against inflation, both on the price inflation and monetary inflation fronts. Real rates, which indicate the relationship between interest rates and inflation, are seen as a key indicator for gold. When real rates are negative, investors seek inflation-proof assets that offer a positive real return. Bonds, which currently do not provide a positive real return, can lead investors to consider alternatives like equities, commodities, and gold. The speaker also highlights the potential regime shift in the gold market, suggesting that it may be indicating a belief that real yields will be negative for a prolonged period, leading investors to allocate out of bonds into real assets like gold.
Jurrien Timmer, director of global macro research at Fidelity, joins Forward Guidance to explain his outlook of the current macro environment marked by slowing rates of growth and inflation coming down from high levels as central banks scramble to tighten monetary conditions. Timmer notes that while risk-free rates (as measured by Treasury yields) have risen sharply, risk premia as measured by credit spreads - and, in particular, the earnings yield of stocks - have barely budged.
Timmer shares his outlook on bonds, commodities, equities at this point in the economic cycle, and he explains his long-term bull case for Bitcoin, as well as why one of his models indicates gold is severely undervalued (not investment advice). Nothing Timmer or Farley say is investment advice.Follow Jurrien
Timmer on Twitter @TimmerFidelity
Follow Jack Farley on Twitter @JackFarley96
Follow Blockworks on Twitter @Blockworks
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