Is the Overheating Economy Cooking Your Portfolio?

This past week saw interesting and polarizing news, as the CPI and PPI releases yielded mixed feelings in the market. CPI rose 0.5%, which CNBC noted was in line with expectations based on the consensus from economists surveyed by Dow Jones, and Core CPI came in lower than expectations, rising only 0.3%. However, as outlined by MarketWatch, PPI jumped up higher than expected, rising by 1% compared to a 0.6% expected increase based on a poll of economists surveyed by the Wall Street Journal.

Some believe that the slowing behavior of CPI growth is reason to believe that the overheating economy is a transitory trend. However, others point to the increasing rate of PPI growth and the July PPI number coming in higher than expectations as evidence that the concerns around inflation are very much justified. There’s even a third camp emerging of those concerned about the economy falling into a stagflation environment. The economic re-opening shows signs of decelerating as the Delta variant rampages while inflation continues to rise.

No matter which group you fall in, it’s clear that inflation is top of mind for the investment community. So this week, we will leverage the Inflation factor from the Axioma Worldwide Macroeconomic Projection (“Axioma Macro”) risk model to investigate which segments of the market deserve the most focus from investors grappling with inflation-induced anxiety.

Getting Our Bearings on Inflation Exposure

As we’ve noted in past analyses using the Axioma Macro risk model, we can interpret the factor exposures as a stock’s beta sensitivity to the factor. This implies that it is especially crucial to understand the trends and distribution of the factor exposures because they are more susceptible to non-normalities and rapid change. Thus, to orient ourselves around the Inflation factor, we can first review the distribution of factor exposures for the Russell 1000.

Interestingly, the Inflation exposures for the Russell 1000 stocks have declined on a year-to-date basis. After reaching a peak of 9.2 in late March, the median exposure plummeted to its current level of 3.7. The 95th percentile saw an even steeper trend, falling from a YTD high of 20.1 in March to the current level of 9.8. Not only did the exposures decrease across the board, but the dispersion of exposures across the index tightened as well. This tightening indicates that the Russell 1000 securities are all converging in their levels of exposure while general sensitivity to inflation has declined.

We can also break this down by sector by calculating the median Inflation exposure across the 11 sector SPDR ETFs.

XLE, the Energy SPDR ETF, shows the highest median Inflation exposure by a significant margin; this is followed by XLY, the Consumer Discretionary SPDR ETF, and XLF, the Financials SPDR ETF. Conversely, XLP, the Consumer Staples SPDR ETF, shows the lowest Inflation exposure. The remaining sector ETFs are relatively clustered together, especially at their current levels.

While it is clear that energy has the heaviest inflation sensitivity, a different sector emerges as the leader when we focus on dispersion measured by the spread between the 95th and 5th percentiles.

XLY (Consumer Discretionary SPDR ETF) consistently shows the most significant dispersion of any sector and even beats out the Russell 1000 for most of the YTD period. While XLE overall may have a high sensitivity to inflation, the most sensitive consumer discretionary stock looks much different from the least sensitive stock.

As intuition would tell us and the data confirms, if you are an investor focusing on the energy sector, where Inflation exposures are high and dispersion within the sector is low, you are almost certain to find your portfolio to be quite sensitive to inflationary pressures. However, suppose you’re focused on sectors like consumer staples, where the Inflation exposures are generally low, or consumer discretionary, where the dispersion of exposures is very high. In such cases, you may likely find your portfolio underexposed to rising inflation vs. the rest of the market.

Inflation Volatility is On the Rise

One might view the above analysis as a sign that inflation is a transient concern related to a direct impact on equity assets. As a result, assets across the market are becoming less sensitive to the Inflation factor, and dispersion is generally decreasing. However, even though asset sensitivity is waning, the predicted volatility of the Inflation factor suggests a different story.

After several months of declining volatility from earlier this year, the trend reversed in May 2021 and has been rising since, currently at 0.72%. The 10-year average volatility is only around 0.55%, which tells us that Inflation exposure is riskier than historically. This heightened exposure means that the 95th percentile Russell 1000 stock with a current Inflation exposure of 9.8 could experience a performance impact of 7.1% if the Inflation factor realizes the level of volatility predicted by the risk model. For the 95th percentile stock in the Energy SPDR ETF with current exposure of 14.6, the performance impact could be upwards of 10.5%.

The above analysis highlights that inflationary pressures can easily overpower sector allocation and alpha research within sectors depending on your specific sector exposures. The future is still unclear about inflation as the economy continues trying desperately to reopen. However, investors should always remain wary and seek transparency on the inflation sensitivities in their portfolios.

US & Global Market Summary

US Market: 08/09/21 - 08/13/21

• Both the S&P 500 (+0.7%) and Dow (+0.9%) ended up for a second consecutive week, while the Nasdaq finished slightly down (-0.1%).
• The University of Michigan’s consumer sentiment index saw a dramatic drop to 70.2 for its preliminary August reading (vs. consensus estimate of 81.3). This is the lowest it’s been since 2011, driven by concerns around the delta variant and subsequent measures being taken.
• As discussed in greater detail above, July CPI came in at +0.5%, in-line with consensus estimates, representing an increase of +5.4% over the past 12 months.
• Core CPI was up +0.3% vs. consensus of +0.4%. The highest YoY increases were in car rentals (73.5%), gas (41.8%), used cars (41.7%), hotels (24.1%) , and airfare (19%).
• Meanwhile, PPI increased by +1% vs. the consensus expectation of +0.6%.
• The US Senate passed both a bipartisan infrastructure bill and a budget resolution, but many challenges and political maneuvers remain before they make it through congress.

Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)

• Value vaulted back towards the mean by another +0.67 standard deviations and was again the week’s biggest winner. This factor recently bottomed out at -2.22 SD below the mean on 7/8.
• Momentum headed higher into positive normalized territory, now at +0.43 SD above the mean.
• Earnings Yield climbed deeper into Overbought territory, now at +1.48 SD above the mean.
• Profitability rose by another +0.12 standard deviations and remains an Overbought factor at +1.5 SD above the mean, although it appears to be slowing down.
• Volatility appears to no longer be in free-fall, as it only fell by 0.09 standard deviations. We recently discussed this factor at length in a multi-part series - here’s the most recent article.
• Size fell out of Overbought space, and now sits at +0.87 SD above the mean.
• Growth took the biggest hit this week, falling -0.58 standard deviations and getting close to exiting Overbought territory. This factor recently peaked at +2.12 SD above the mean on 7/23.
• US Total Risk (using the Russell 3000 as proxy) decreased by 45 basis points.

‍Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)

• Global Value also continued its rally, up another half standard deviation and shedding its Oversold label. It now sits at -0.77 SD below the mean, after hitting trough at -2.22 SD below the mean on 7/21.
• Market Sensitivity is still reverting back to the mean after reaching -0.9 SD below the mean on 7/30.
• Momentum is now in knocking distance of becoming an Overbought factor as it sits at +0.98 SD
• Earnings Yield appears to be ticking down now after peaking at +1.83 SD above the mean on 8/9.
• Similar to the US, the bleeding in Volatility slowed to a relative trickle after the recent crash. It’s still Oversold at -1.2 SD below the mean.
• Exchange Rate Sensitivity remains an Oversold factor at -1.3 SD below the mean.
• Growth fell by 0.28 standard deviations and is on pace to lose its Overbought label as it heads back towards the mean. This factor hit a recent high of +1.56 SD above the mean on 7/26.
• Global Total Risk (using the ACWI as proxy) decreased by 14 basis points.

Regards,
Alyx