Themes That Will Outperform In A Market Correction
The pressure on the Fed to move toward rate normalization after the election will be intensifying. GDP growth is likely to pick up to 2½-3% in the third quarter. Moreover, the annual inflation rate could easily be more than double the latest reading by the coming winter. Even with the latest pullback, crude oil prices have risen over 60% from their February 11th lows. If one merely assumes oil prices remain at current levels for the next 4-5 months and then calculates the year-over-year change, the yearly change in oil prices would have a stunning run. From the lows in February, the year-over-year change in monthly oil prices would surge from minus 40% to plus 47.5% by early 2017.
Energy accounts for only 7.2% of the CPI and it doesn’t swing as wildly as crude oil. That is because about half of the energy sub-index of the CPI is electricity. But most of the other half (3.3% of the total CPI) is gasoline, which swings just as wildly as crude. Nevertheless, the surges are so huge that oil going flat from here would mean a CPI headline that could be multiples of the recent 1.1% print by next winter, other things being equal. The impact would dissipate by late spring as year-over-year comparisons fall to zero, unless, of course oil prices rise further. But we estimate oil will have a dramatic further rise to the $60-80/bbl range, keeping continuing upward pressure on the overall CPI.
As it is, the consensus of economists is calling for a rise in the CPI Y/Y from the current 1.1% to over 2% by early next year. The core CPI, afterall, is already at 2.3% and core services are already at 3.2%. Based on the calculation above, we think the total CPI could be a lot higher. As this scenario unfolds, FOMC members are likely to stick to a more hawkish path for Fed Funds and the Dot plots in December and March should reflect that. With the uncertainty about the presidential election outcome, both stocks and bonds could be in for a pretty rough sledding this winter.
Even in a broad capital market decline in stocks and bonds, however, there are always some securities that will outperform relatively, if not absolutely. For example, the S&P 500 can be broadly divided between value stocks and growth stocks. For over eight years, growth had handsomely outperformed value; but it looks to us as though that trend has begun to reverse, and value should outperform growth by a wide margin for the foreseeable future. The present value of future earnings growth will be revised down when interest rates rise, affecting growth stocks disproportionately; value stock sectors should smartly beat growth as rates one way or another go higher. We maintain our value over growth stocks theme.
The rise in U.S. inflation will likely lead to the continued rolling over of the U.S. dollar . Gold and gold mining stocks , an MRP theme since October 2015, would act as an inflation-hedge. Moreover, the energy sector is in the midst of a structural flux that will have significant implications for energy prices in the near-to-intermediate term. As the global thirst for crude oil rebounds in emerging economies such as India and China, and from record breaking miles driven in the U.S., the ability of the supply side to meet demand will become increasingly difficult – creating an oil shortage and higher prices. Energy is a theme we added in early April.
Lastly, it is clear that rising Fed Funds will eventually push up mortgage rates. Some will argue that rising mortgage costs will be a headwind for the housing sector, but we would argue that powerful demographic forces will overshadow that negative.
For more info about receiving MRP's thematic investment recommendations contact Rob Davis at 646-964-6152 or through your Harvest connection.
