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As Inflation Rates Rise, Look to Financials, Small-Cap Stocks

A panel of market observers from Informa Financial Intelligence see strong headwinds hitting an overly exuberant market.

Even as the economy appears to be picking up in the wake of Americans getting the COVID-19 vaccine and the Biden administration’s stimulus measures, the outlook for the market remains uncertain and headwinds abound.

A group of market observers from Informa Financial Intelligence last week discussed current market conditions, their predictions for inflation, and how advisors may want to think about rebalancing their clients' portfolios.

Despite the "soothing forecasts" coming out of the Federal Reserve and from Biden's policymakers, there's a growing fear that all the stimulus spending will bring about a jump in inflation, said Cameron Brandt, director of research at EPFR.

Indeed, inflation in April rose 4.2% from this time last year, its fastest pace in more than 12 years, according to the Consumer Price Index report from the Labor Department released Wednesday morning. The number topped most expectations and sent markets tumbling.

Brandt pointed out that the investors have been expecting something like this. Since the middle of last year there have been only two weeks where inflation-protected bond funds experienced outflows. The rest of the time inflows were above their historic average.

He added that the bank loans known as floating-rate funds, which adjust their payments alongside fluctuations in interest rates, have seen strong interest recently.

These "are a classic vehicle you turn to if you think short-term interest rates or some of the other key markers, like LIBOR (London interbank offered rate) or SOFR (secured overnight financing rate) are about to head higher," said Brandt.

As incomes rise across the income distribution chain, and companies experience limited supplies of goods, "if prices didn't go up quite sharply, I'd be very surprised,"  he said.

U.S. Treasury inflation-protected securities (TIPS) are Treasurys indexed to inflation. When inflation rises, so do the security's principal amount and the associated interest payments. The yield spread between TIPS and the regular U.S. Treasurys with the same maturity indicates how much investors are willing to pay for inflation protection.

Two of the best performing TIPS ETFs over the past year include: the Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL) and the Pimco 1-5 Year  US TIPS ETF (STPZ).

IVOL is up 11% over the past 12 months, and 4.5% year to date (May 10), according to Morningstar. STPZ is up 2.8% year to date and 7.4% over the past year.

Meanwhile, the SPDR Portfolio Intermediate Term Treasury ETF (SPTI) is down 2.0% year to date and 1.9% over the past 12 months.

In inflationary times yields typically rise. Ryan Nauman, market strategist at Zephyr, a portfolio reporting platform for financial advisors, said financials remain the cheapest sector out there and should benefit from a robust economic recovery.

"They continue to be very attractively valued, relatively speaking, and they'll continue to benefit from rising rates and the reduction of their loan loss provisions," he said.

Year to date, the First Trust NASDAQ Bank ETF (FTXO) is up 36.3%, according to Morningstar, and the SPDR S&P Regional Banking ETF (KRE) is up 35.5%.

Nauman also likes small-cap stocks, which offer a better hedge and tend to outperform during inflationary periods. Relating to Biden's spending plans, he said that industrials, materials, and cyclical sectors should benefit. He added that even though energy stocks have been the best sector for the past six months, they still have room to run as travel picks up from pent-up demand.

Among small-stock and energy ETFs, the iShares Russell 2000 ETF (IWM) is up 12.2% year to date, and the Vanguard Energy ETF (VDE) is up 44.5%

There are also great contrarian opportunities, said Brandt. The pent-up demand gets even more pent-up the worse your COVID-19 story is.  

"Europe, India, and parts of Latin America, I think are going to provide some very interesting short-term opportunities over the next six months," Brandt.

If Europe improves on the vaccine front, then the market will become optimistic about European growth, said Jonathan Cavenagh, senior market strategist at Informa Global Markets. So far, this year has been all about the U.S., but if the growth momentum tilts toward the European Union that can drive the euro higher and other currencies will follow.

Year to date, the Vanguard FTSE Europe ETF (VGK) is up 12.9%, the First Trust India NIFTY 50 Equal Weight ETF (NFTY) is up 15%, and the iShares Latin America 40 ETF (ILF) is up 2.9%, according to Morningstar.

However, many risks remain, and the market could face significant headwinds over the rest of the year.

"One risk is that the vaccine roll-out falters or we don't really see it helping develop herd immunity, and economies need to go back into inter-lockdown," said Cavenagh. If that happens, "a lot of positions that have been built up this year get unwound very, very quickly."

The second big risk Cavenagh sees is aggressive inflation, which forces the Fed to get much more active. He said this will be a big issue for emerging markets and will spill over into a lot of other asset classes.

Brandt fears that Europe's politics could turn sour. Germany will be holding an election this year, and he fears that if it is unable to form a coalition government that will sap a lot of energy from any recovery. France, too, is a concern for investors.

"France remains, for me, a real worry," said Brandt. "Its debt dynamics are terrible. Its politics are extremely fragmented. ... European politics might yield a nasty surprise."

Nauman said technology is under pressure due to higher yields and the shortage of semiconductors due to supply chain bottlenecks. This is affecting all the sectors across the board.

But the biggest risk he sees is that "excessive investor exuberance could lead to excessive leverage, which could ultimately accelerate a market sell-off." He pointed out that margin debt is currently at pre-dot-com levels.

"Investor sentiment surveys indicate mounting optimism," said Nauman. "The prices that people are paying for mean stocks and mean crypto-currencies, collectibles and NFTs (non-fungible tokens) are obviously a joke. It all feels like we're in the midst of a bubble," he said.

He said the root of this exuberance is that massive amounts of virtually free money in the system give investors optimism, and many are motivated by a fear of missing out on the next Tesla or Bitcoin.

The next trigger for a sell-off could be another hedge fund blowup, he said, like the recent implosion of Bill Hwang's Archegos Capital Management, where leveraged bets in ViacomCBS turned south sparking a $20 billion wave of forced liquidations at many Wall Street banks, such as Nomura and Credit Suisse.

The market seemed to absorb the Archegos liquidations, but it’s possible it’s only the first of more to come.

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