Gravity Exists

discussion

A Strategic Approach to Inflation

April 18, 2022


Jason De Sena Trennert co-founded the research boutique Strategas in 2006 after leaving his role as Chief Investment Strategist for ISI. Strategas provides investment research to asset managers and institutions and employs over 50 professionals in its New York and Washington DC offices. Early this year, Strategas launched two exchange-traded funds investing in equity markets. Gravity Exists spoke with Trennert about how he and his team anticipate inflation will impact markets and how they manage these risks in their portfolios.

We just witnessed another multi-decade high print for CPI and PPI last week, yet most investors appear to remain sanguine with a consensus that “peak inflation” was achieved in March. Where do you come in on that debate?

I think inflation is likely to come down gradually, but I remain skeptical we’ve experienced the peak. Certain elements of inflation may prove fleeting, but we are still facing profound structural drivers for rising prices. Keep in mind the Fed has only tightened by 25 basis points so far. It will take a long time for the FOMC to achieve their end goals.

Do you then think that the US is facing possible stagflation?

It seems unlikely to me given how aggressive the Fed’s comments have been, but it remains a possibility. As we see it, there are only three likely outcomes. One is the ideal scenario in which inflation does prove to be transitory, and the Fed successfully navigates a soft landing. That would be the best outcome, but it seems less likely than the second — that the FOMC succeeds in taming inflation but, in doing so, takes the economy into a shallow recession. Stagflation would be the third and, in our view, the least likely, scenario based on current facts. It would likely be the result of a resurrection of the ‘Fed Put.’

How rapidly do you think the Fed will tighten?

I suspect that the FOMC board members are embarrassed at the situation they find themselves in now. They are viewed broadly as complicit in allowing inflation to reach these levels. It seems likely they will fight inflation aggressively to protect their political and professional standing. I like to tell investors we are experiencing the death of the ‘participation trophy’ economy. As rates rise and the Fed’s balance sheet shrinks, access to capital will be rationed. The end of quantitative easing will punish businesses that don’t generate profits, aren’t positioned competitively, or are unable to pass through rising business and debt service costs to customers.

As a portfolio strategist, how are you advising your clients to position portfolios based on this macro view?

Generally, we believe people should hold more cash and wait for better buying opportunities. Where they remain invested in fixed income, we think that they should focus on keeping the duration short. The yield curve has flattened, even inverting for a brief period. While there is a lot of discussion of its meaning in terms of the likelihood of recession — or what the Fed thinks is the likelihood of a recession — the more significant point is investors are anticipating a slow down for businesses in general. Although the default risk for corporate bonds remains low, I still expect that spreads will continue to widen and that risk assets will generally remain overpriced.

People should also look for what we call “shorter-duration equities.” This is a fancy way of saying investors should focus on companies that pay their investors back, either through share repurchases or dividends, to provide some degree of a hedge against inflation. Those companies sit in contrast to the tech stocks trading at ten times sales that led the market in years prior. In our opinion, those types of companies will act like zero-coupon bonds as rates rise.

Your firm recently entered the asset management business with several equity ETFs. How are you applying this advice within your portfolios?

We look for stocks that will thrive despite inflationary pressures and quantitative tightening. We refer to these companies as ‘cyclical defensives,’ meaning they have business models that combine cyclical and defensive elements. They should be used as core equity allocations for investors that want to play active defense. We are a macro research firm, and as analysts, one of our key jobs is to identify developing themes. We focus on these thematic inflections to construct the portfolio in our Macro Thematic Opportunities Fund (SAMT). Right now, that means we have a strong value tilt with heavy exposure to sectors that have outperformed historically during inflationary periods. There isn’t a lot of data for stock performance during quantitative tightening cycles, obviously, but we have modeled historical corollaries where the sizes of balance sheets declined, and globalization was threatened. As a result, we are concentrated in high-quality companies in sectors like energy, aerospace and defense, cyber security, and even some consumer staples and healthcare segments. We view these as high-quality businesses that should continue to grow despite a challenging environment.

Your firm is known for policy research. Does that impact stock selection in any way?

We believe our policies work is a major differentiator. We have had a Washington office since 2007, and doing deep-dive analysis into the tug-of-war between the interests of the private sector and public policy is foundational to our work. Our Global Policy Opportunities (SAGP) portfolio focuses on companies with the best lobbying efforts. These companies have a significant presence in DC and are positioned to influence policy regardless of the party in control in Washington.

The energy industry is a segment where policy debates impact your portfolio. Has the war in Europe changed your view of prospects for the sector? It had had a significant impact on fuel prices, obviously.

[Fuel prices are] not purely a function of the war, in my opinion. US environmental policies, particularly the focus on transitioning away from fossil fuels, were already putting upward pressure on oil and gas prices before the war began. Until policies become more friendly to the oil and gas industry in the US, I believe oil and gas prices will be higher than historical averages and that they will stay higher longer. The irony here is that the ESG movement and the Biden administration have made energy companies much better investments. The Trump administration’s unabashed love of the fossil fuel industry played into the worst instincts of the people who run energy companies by looking to punch another hole in the ground. Today, the sector is far more disciplined from a capital investment perspective.

In your experience, has this translated to a willingness among allocators to increase exposure to fossil fuels despite ESG mandates?

The mandates are the mandates. But I do believe that allocators are beginning to accept that being underweight in the energy sector may hurt their portfolio’s performance over the next several years. In the past 12 years, the energy’s weighting in the S&P 500 has fallen from 16% to 4%. ESG investing was easier in that period, obviously. Now, I think it’s going to get harder. I would suspect — believe it or not — that some energy companies will be seen as ESG-compliant in the end.

Strategas CEO Jason De Sena Trennert remains skeptical peak inflation has been achieved yet.

Jason De Sena TrennertStrategas CEO Jason De Sena Trennert remains skeptical peak inflation has been achieved yet.