- Top strategists at BlackRock, JPMorgan, and elsewhere have singled out an elusive trend as the most overlooked risk to the stock market in 2020.
- They also provided guidance on how investors can protect their portfolios against this risk.
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“Don’t fight the Fed” is sage advice on Wall Street that usually pays off if you heed it.
Just over a year ago, the Fed signaled that it would open the spigots of liquidity amid a slowing global economy. It did just that throughout 2019 by restocking its balance sheet and intervening in the market for repurchase agreements.
Market bulls took the Fed’s cue and smiled all the way to the bank as the market made new highs.
But during the course of the year, the Fed sent another consequential message to the market that slid under the radar: it signaled its willingness to let inflation run a bit hot before intervening with interest-rate hikes.
The risk of higher inflation is still being underappreciated by investors at large, according to strategists at heavyweight firms including BlackRock, JPMorgan, and Morgan Stanley. In addition to flagging the risk of inflation, which refers to higher prices across the economy, they are offering trade recommendations on how to hedge against it.
None of these firms are confident that inflation will make a fierce comeback. After all, inflation has struggled to meaningfully exceed the Fed’s 2% target despite the lowest unemployment rate in 50 years.
However, other factors like higher commodity costs, wage increases, and a weaker dollar are potent wild cards that can arrive at any time to stoke inflation. These firms are cognizant of the fallout, and they want their clients to be ready.
Without further ado, here’s what they are saying about the risk of inflation and how they are advising investors hedge it.
The risk of higher inflation is being underappreciated not just for 2020 but beyond, says Mike Pyle, global chief investment strategist at the world’s largest asset manager.
At the very least, Pyle expects modestly higher inflation this year thanks to rising wages and energy prices.
He found that from 1997 through 2019, stocks performed worst relative to Treasuries and Treasury Inflation-Protected Securities when inflation was higher. And so he recommends TIPS as a hedge.
“We like TIPS on a tactical basis but would avoid inflation-linked bonds in the euro area or Japan as inflation expectations still appear depressed but actual inflation rates are stubbornly below central banks’ targets,” Pyle said in a note.
“On a strategic basis a blend of nominal and inflation-linked US government bonds could create resilience to a variety of adverse conditions, including both growth and inflation shocks. We also tilt toward US Treasuries for portfolio ballast, as European and Japanese government bond yields appear to near lower bounds, diminishing their ability to cushion portfolios.”
If inflation rears its head, you won’t want to be heavily invested in sectors of the market that serve as so-called bond proxies.
That’s because these sectors, loved for providing bond-like income in times of volatility, became ultra-popular last year when investors had good reason to believe the economy was heading for a recession.
They are now richly valued and, like bonds, are vulnerable to an environment of better-than-expected growth and stronger inflation, said Dubravko Lakos-Bujas, the chief US equity strategist and global head of quantitative research.
He sees many investors still parked in stocks that benefit from interest rates staying low or falling.
“Momentum, in particular low-volatility stocks, remain significantly exposed to duration risk (i.e. if bond yields were to rise),” Lakos-Bujas said in a note. He further called this duration risk “the biggest pain trade” for investors in 2020.
He added: “Looking ahead to 1Q20, we recommend investors overweight Value, stay neutral Growth, and underweight Momentum, Low Vol and Quality.”
Morgan Stanley’s message is that a little bit of inflation on its own is not bad for stocks.
But inflation that comes without economic growth — otherwise known as stagflation — is where things could get complicated.
To detect if both trends are not advancing in tandem, look no further than cyclical stocks that are exposed to economically sensitive sectors like industrials and energy, says Lisa Shalett, the chief investment officer of Morgan Stanley Wealth Management. If cyclicals do not gain when inflation rises, take that as a sinister sign for the economy’s future.
“Investors need to avoid complacency and consider positioning their portfolios defensively, in case growth slows while inflation continues to rise,” Shalett said in a note.
“Look for companies with pricing power or the ability to benefit from higher commodity prices, such as oil producers. I also suggest adding some real assets, such as real estate investment trusts or commodities, as a hedge in 2020.”