Inflation Is Surging. Here Are Some Portfolio Changes to Consider.

What happens next with inflation may hold the key for market direction going forward, said Jim Cielinski, global head of Janus Henderson’s fixed-income markets, said somewhat presciently at a Wednesday virtual conference to offer advisors guidance on portfolio construction. “A lot of what we are seeing (in global economies) is not nearly as transitory and short-lived as many had thought,” he said. Still, “supply-chain issues are starting to resolve.”

That would go a long way to help quell the current inflation-driven “fear trade.” Indeed, global shipping titan Maersk recently predicted that supply-chain issues and freight rates will begin to normalize early in the second half of the year. 

The Federal Reserve is surely keeping a close watch on supply-chain-driven inflationary pressures. While at least three or four rate hikes are highly likely this year, according to Cielinski, the Fed may not feel compelled to keep raising interest rates after that. That could be a surprise to market watchers who anticipate a more extended period of rate hikes. 

“The panic that rates will shoot to the moon appears to be off base,” said Cielinski. He predicts that the 10-year Treasury yield, which reached 2% after Thursday’s CPI news, may not rise much further this year as increases in short-term rates slow the economy enough to blunt inflationary pressures. 

If he is correct in that view, then longer-dated bonds may come back into favor with fixed-income investors once the 10-year Treasury yield stabilizes. In recent quarters, with expectations that rates would be rising, many investors have focused on short-term bonds to avoid duration, or interest-rate, risk.

An ongoing rotation. Even if inflation starts to cool, investors shouldn’t count on a quick reversion back to the hottest sectors that were in favor before the recent market turmoil. 

“We’re done with the era of high valuations for preprofitable or even prerevenue companies,” said George Maris, co-head of equities at Janus Henderson. That would bode ill for once-highflying tech stocks that have come crashing down to earth. He adds that “with inflation and interest rates set to settle down at a higher plane than before, investors will focus more on valuations.” Maris’ colleague, Alex Crooke, co-head of equities for the EMEA and Pacific regions at Janus Henderson, agreed.

“Since the start of 2022, we’ve seen a big rotation out of growth into value,” noted Crooke. As just one example, the Vanguard Growth ETF (

VUG
) has fallen more than 10% thus far in 2022, according to Morningstar, whereas the Vanguard Value ETF (

VTV
) is modestly in the black year-to-date.

Look for more of the same in the coming weeks and months.. “The macro backdrop will continue to favor value, even after the recent outperformance,” he said, adding that “value stocks continue to trade at an unusually large discount to growth stocks.” 

Maris also sees a looming rotation away from megacap stocks and into small caps. He notes that after a remarkable multiyear run-up, the five largest stocks (

Apple
,
Microsoft, Tesla, Amazon, and Alphabet) account for 50% of the Nasdaq 100, and 25% of the S&P 500. Those firms are starting to see growth rates mature, even as they sport high valuations. Market favorite

Apple
,
for example, saw sales surge 33% in fiscal (September) 2021 yet is expected to post revenue growth of 8% this year and 6% next year, according to consensus forecasts. 

If Maris is correct that a rotation away from megacap tech stocks may play out in 2022, “then smaller-cap stocks, by definition, could do comparatively much better this year,” he said. 

Know Your Alts. Advisors have more closely embraced alternative investments in recent quarters to reduce exposure to traditional stock-and-bond portfolios. Yet each type of “alt” asset class will have distinct outcomes in the changing economic environment, according to David Elms, head of diversified alternative assets at Janus Henderson. “Some investments, such as private debt and private equity will mirror their public market counterparts if interest rates move higher.” he said. “Private equity is particularly sensitive to rates as PE firms use debt leverage in their business models,” he adds.

Instead, Elms suggested that investors seek out assets that will benefit from inflation, such as commodities. He also thinks that “trend following” funds may fare well in 2022. These funds follow existing moves in an asset class, such as a downward move in the value of growth stocks or an upward move in commodities or interest rates. 

Indeed, the Hedge Fund Research’s (HFR), Trend Following index has risen more than 8% over the past 12 months. More recently, the LoCorr Market Trend Fund (

LOTAX
) has risen more than 7% thus far in 2022.

A Rebound for China? While the Janus Henderson conference covered a range of markets and themes, a look at Chinese equities was particularly compelling.

Mike Kerley, a Janus Handerson portfolio manager covering Pacific equities, noted that the MSCI China index underperformed the S&P 500 in 2021 by a stunning 49 percentage points, “the largest gap ever.” That massive drop came even as the Chinese economy grew 8% last year. 

The market slide is due to a lack of fiscal and monetary stimulus in China (whereas most other countries introduced asset-inflating stimulus funding), tighter regulations on many domestic firms, a zero-tolerance Covid policy that led to widespread lockdowns, and an increase in commodity costs, according to Kerley. China remains a voracious importer of commodities.

Yet Kerley sees the possibility of green shoots in 2022. “The government is loosening monetary policy and will have a more focused fiscal policy to guard against any pockets of economic weakness,” he predicted. “China will be the only major economy loosening its policies in 2022,” concluded Kerley. And he added that the “regulatory news flow has peaked” and should abate in 2022 as the country moves to implement the policies discussed in 2021. 

In an era of tightening global monetary conditions Chinese stocks may emerge as the comeback winner of 2022.