SPY - A Major Market Surprise Is Likely Coming

2023-11-24 07:00:00 ET

Summary

• High inflation has been the dominant economic theme over the past two years, and higher-for-longer interest rates are currently priced into much of the market.
• However, major economic trends are shifting, which we believe will lead to a major market surprise in the coming years.
• We share how we are positioning our portfolio to profit from this anticipated surprise, including a few of our top picks of the moment.

Over the past two years, battling persistently high inflation has been the dominant economic theme facing markets. However, major economic trends are shifting, which we believe will possibly lead to a reversal from inflation to deflation in the near future. In this article, we explain why we expect this major market surprise and share how we are positioning our portfolio to profit from this anticipated macroeconomic reversal, including a few of our top picks of the moment.

Why A Major Market Surprise Is Coming

Given that inflation and related interest rate hikes have dominated market sentiment since early 2022, the market has largely priced in higher-for-longer interest rates. This is clearly evidenced by the large drawdowns in many utilities ( XLU ), REITs ( VNQ ), and yield cos like Atlantica ( AY ), NextEra ( NEP ), Brookfield Renewable ( BEP )( BEPC ), and Clearway ( CWEN )( CWEN.A ) over that time period despite enjoying pretty strong fundamentals:

As a result, any material decline in interest rates would likely cause a very strong market reaction, sending these stocks soaring higher as a result.

However, we believe that inflation is not only likely headed lower, but that deflation could very well be in store in the near future as well. Cathie Wood, the CEO of ARK Invest ( ARKK )( ARKQ ) - known for her bold investments in disruptive technology companies - recently shared her view that we are on the brink of a transition from an inflationary period to a deflationary one due to technological advancements and the Fed's overly aggressive interest rate hikes over the past two years. She believes that technological innovation - particularly in the areas of artificial intelligence and robotics - will lead to increased productivity and lower costs, thus driving prices down and having a massive deflationary impact on the economy. Moreover, she criticized the Federal Reserve's aggressive interest rate hikes as being excessive for what was necessary to bring down inflation, and as a result, the economy may be in store for deflation in the near future.

While some may dismiss her outlook as being influenced by the fact that her investments tend to thrive in periods of low-interest rates, recent economic data supports her theory that we are on the cusp of a shift towards deflation. For example, recent data indicates that there has been a steep decline in commodity prices as well as in new and used car prices and airfare. Moreover, CEOs of retail giants like Walmart ( WMT ) and Home Depot ( HD ) have recently observed a deflationary trend in retail prices. On top of that, the commercial real estate market faces challenges with impending debt refinancing, which may have a further deflationary impact on the economy as rent costs will likely fall for many companies moving forward and the unemployment fallout from a major downturn in the huge commercial real estate sector will also likely make a dent on consumer spending. Last, but not least, the labor market shows signs of cooling, with slowing job growth, increasing unemployment, and a decline in consumer sentiment and real wages. As a result, lower wages and weaker consumer demand for goods and services are likely on the way, further adding to the deflationary spiral.

Another potential addition to deflation could be a sharp pullback in in the S&P 500 ( SPY )( VOO ), which until now has held up quite well and is in fact quite overvalued according to most metrics. When people's investments are doing well, they tend to feel more financially secure and therefore are more likely to spend money. However, when the stock market crashes, it has the opposite effect on consumer behavior. As a result, should the market correct to a more normalized valuation level, consumer behavior may take an additional hit. The same can also be said of home equity, which is likely being artificially inflated at the moment due to historically high home valuations .

In fact, the U.S. CPI - the most popular metric for inflation - has shown a dramatic decline over the past three months and is now on the cusp of turning deflationary:

In fact, given that shelter's role in CPI often has a considerable lag, and there is strong evidence to suggest that future shelter CPI contributions will be deflationary, a case can be made that we may already be experiencing deflation at the moment. Regardless, should the aforementioned trends continue, it is entirely possible that we will see some deflationary readings on CPI at some point in the near future. If this were to happen, it is very likely that the market would be shocked and the portions of it that have been beaten down due to the higher-for-longer interest rate narrative would likely shoot higher.

Our Approach

If we are indeed in store for a major market shock as the economy whipsaws from four-decade-high inflation to deflation in a mere matter of a few years, it means that the economy will quite likely be suffering from a meaningful recession and that there is an enormous opportunity to generate alpha as an investor.

While some parts of the market - particularly among the leading A.I. companies like Palantir ( PLTR ), Meta ( META ), Alphabet ( GOOG ), Microsoft ( MSFT ), Apple ( AAPL ), NVIDIA ( NVDA ), Amazon ( AMZN ), and Tesla ( TSLA ) - are trading at or near historically high valuations right now despite the elevated interest rates weighing on equity valuations, there are other areas of the market which - despite the underlying companies boasting solid fundamentals - have been beaten down severely due to market consensus that we are in store for higher-for-longer interest rates. Moreover, if just so happens that many of these businesses are also recession-resistant.

As a result, in a scenario where the economy goes into a very low inflation or even deflationary environment while also tumbling into a recession, interest rates will likely tumble as well due to the Federal Reserve no longer needing to hold rates at restrictive levels as well as feeling compelled to revive the economy out of its recession. This will likely result in these interest rate-sensitive, recession-resistant stocks massively outperforming the rest of the market.

Therefore, while we are big believers in maintaining a diversified portfolio, we are also overweighting our allocation to sectors like defensive REITs, utilities, yield cos, and other contracted infrastructure assets. Some of our favorite picks of the moment include:

• Realty Income ( O ) - a high-yielding, A- rated, triple net lease REIT that trades at a historically low valuation and has a phenomenal track record of compounding wealth and growing its dividend over the long-term while also weathering recessions exceptionally well.
• Algonquin Power & Utilities ( AQN ) - a high-yielding, investment-grade regulated utility that trades at a historically low valuation and is in the process of selling its renewable power production business (which they expect to execute in 2024) at a valuation that they believe will unlock value for shareholders. It has suffered from rising interest rates despite generating solid underlying performance and therefore would benefit immensely from a decline in interest rates while weathering a recession quite well.

Investor Takeaway

We believe that a potential impending shift from high inflation to deflation presents a very attractive risk-adjusted opportunity to investors right now. Yes, it is true that there is also a strong case to be made for sticky inflation moving forward, and we should therefore express caution in fully embracing the deflation narrative. One reason to be concerned about persistently high inflation for years to come include 'de-globalization' efforts like trade sanctions and reduced reliance on foreign products, leading to increased costs and retaliatory measures by affected countries. Additionally, the wage-price spiral, where high inflation drives wage increases, further fuels inflation, particularly in service-based economies. Third, the high liquidity in global markets, a result of quantitative easing after the 2008 financial crisis, has inflated asset values and limited central banks' ability to combat inflation with interest rate hikes.

That being said, by focusing on sectors like defensive REITs, utilities, and yield cos, which are currently undervalued due to the prevailing high-interest rate environment, investors can capitalize on current market dynamics by offering massive upside potential if low inflation/deflation truly materializes in the near future while having only limited further downside potential in a worst case scenario should interest rates remain in their current range for the foreseeable future.

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