Changing from a deflation to inflation economy: winners and losers

The market snap that occurred in February, seems to have marked a point where markets finally recognized the inflection point from many years of decreasing interest rates to many expected years of increasing interest rates.  The winners and losers of this transition are likely to be different than what we have come to expect over the last 30 years.

We expect two major changes.  Indexes of Stocks, Real Estate, and Bonds were the big beneficiaries of these falling interest rates.  In periods when an asset class does really well, it’s hard for research and trading to have a significant effect.  However, markets go through long periods where trading and research is more effective than at other times.  One change that appears is that we are entering one of these periods where trading and research is more effective.  We expect markets to be more volatile and for stock selection to matter more and more.

A secondary change is which how assets classes like Stocks, Bonds, and Commodities (Gold) should behave.  In a deflationary environment, bonds do really well, followed closely by Stocks.  One way to think of this is if you invested in a bank CD.  As interest rates fall, each CD you buy you look brilliant and you pat yourself on the back.  You might say, “I locked in 5% and then later similar CDs are paying 4.5%”.  Bonds work very similar, so as interest rates fall, your investment gets an extra little push.  However, as we enter an inflation environment, that extra little push becomes an extra little anchor.  Commodities like Gold start getting the extra little push.  Over time, this could have a significant impact to portfolios.  Notice the charts above.  1980 – 2016 deflationary, 1964 – 1980 inflationary

We are expecting 4-5 interest rate increases this year.  While the overall interest rates are expected to stay relatively low, a small interest rate increase on an already low rate can end up being a very large increase as a percentage.  Thus far, we have seen the Barclays Aggregate (AGG) down, about -2.5% year to date.  Markets probably will not change over nights, but you could look back in 5 years and realize that the assumptions about how markets were going to behave was based on the wrong 30 sample.

At Eagle West Group, we are actively involved in monitoring and responding to this change.  Our portfolios are designed to be responsive as the world changes.

I invite you to read the institutional commentary that this article was based on:


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