MARKET UPDATE

With inflation spiking and interest rates rising, David Royal, Thrivent Chief Investment Officer, and Steve Lowe, Chief Investment Strategist, recently tackled some of the key questions facing the market during this turbulent time.

Inflation has jumped to the highest levels since the early 1980s, roiling markets and hitting consumers’ pocket books.

“After being dormant for years, inflation has really surged,” explained Lowe. “But the Fed really struggled to recognize the persistency of inflation, and now they find themselves behind the curve. As a result, they have to play catchup, which means they have to raise rates relatively quickly. That has left the markets struggling to forecast how the steepest and quickest hike cycle since the 1990s will affect the markets.”

The Producer Price Index (PPI), which is commonly used as an inflation gauge, has been running between 9 and 10%, while consumer inflation has risen by about 7% over the past year, driven by strong demand, goods shortages, and rising commodity prices, such as gasoline. The rise in prices not only affects consumers, but it impacts corporate earnings, as well.

“If a company is paying higher prices, they have one of two options,” explained Lowe. “They can either pass it along to the consumer – which is by and large what is happening – or they can absorb the higher prices. But that erodes margins for companies and ultimately impacts earnings. Our expectation is that margins will generally hold up but may drop off a little bit.”

Lowe said that inflation becomes more dangerous when people start to expect it to continue and change behaviors, which may start a cycle of inflation. “Our view is that it will stay higher than it has in the past but will start to ease as supply chains unclog, which could be a year-long process. The market expects that the Fed will be successful at dampening inflation and that supply chain shortages will ultimately ease, and demand will also decline.”

Worker shortage

With 11 million job openings but only seven million unemployed people in the work force, the current labor shortage has increased wage pressure, which translates into inflationary pressure.

“A lot of people left the labor force during the pandemic for a variety of reasons, along with this massive wave of retirement,” explained Lowe. “This labor shortage is concerning for the Fed because what you don’t want is a wage-price spiral. I think this will ease over time as people come back to work, which we’ve seen in recent jobs reports. As more people return to work, that should ease wage pressures.”

“We did see an increase of about 0.3% in the labor force participation rate,” added Royal, “which is good news because the solution to the wage price spiral is to get more people in the work force.”

Fed actions

The market anticipates about seven rate hikes this year, beginning in March with at least a quarter point hike. But exactly how fast the Fed raises rates will depend on how the economy is doing.

“The Fed has two basic tools – rates and the balance sheet,” said Lowe. “Through the pandemic they were buying treasuries and mortgages. That’s going to end in March. And then they’re going to start shrinking their balance sheet – quantitative tightening. That will also work to push up rates.”

Market volatility

Despite the uncertainty and volatility of the current environment, Lowe doesn’t view the market outlook negatively. “Markets can and have performed well during Fed hiking cycles because the Fed is generally hiking when the economy is strong. So, we expect solid returns but more muted than the past two years when we had outstanding returns.”

Added Royal: “Since the 1990s, in periods when the Fed is hiking rates, the markets have typically dropped a little bit and then actually outperformed over time. If recent history is any guide, the next six months after a rate hike cycle could be challenging, but long term, it could be a good time to be in equities.”

Stock market prospects

Different types of stocks can lead the market during different periods in the economic cycle. “During a recession, you have low growth, low inflation, maybe even deflation,” said Royal. “During those times, you want to be in defensive, low beta, low volatility areas, such as large caps, which generally carry less risk and less leverage than small caps.

“As you move into that recovery phase,” he added, “it can be a little counterintuitive. The types of stocks that tend to perform well in that phase are the riskiest stocks, cyclicals, deep value, high beta, low quality companies with high leverage, negative earnings, or poor credit ratings, including small and even micro caps – and we saw that in spades in the first quarter of 2021.”

The economy very quickly moved out of that recessionary phase into the recovery period. “The recovery period is when the economy is still growing but growth is decelerating, and inflation is picking up,” said Royal. “At that stage of the economy, you may want to be in some higher quality names but still cyclical value, defensive value, and areas with growing earnings. You may also want to move up in market capitalization during this period.”

Entering a slow-down phase, Royal believes investors should consider moving to the higher quality, growth momentum, longer duration segment. “As we see signs of economic slowdown – and we will at some point – that’s when you would want to move toward large cap names – like growth and technology. And then to finish the circle, you would want to get a little more defensive as you start to see the economic slowdown progress and perhaps even accelerate.”

The recent market sell-off was led by small and mid-cap stocks, many of which dropped 40% or more. “I view periods like this as an opportunity to buy great growth-oriented companies that are going to benefit from the next phase of the cycle because the sell-off was so indiscriminate,” said Royal.

Where to turn

“The market may decline during a Fed hiking cycle – which usually occurs during a good economy – but those tend to be buying opportunities,” said Royal. “The market rarely goes into a severe bear market unless the economy goes into a recession. And there is nothing in the economic data to suggest that we’re entering a recession in the next few quarters.

“If the Fed gets more hawkish,” he added, “and we see the market sell off as a result, I think we would be adding equity.”

For equity investors in a high inflation environment, Royal suggests investing in a fund such as Thrivent Large Cap Value Fund (TLVIX), “which holds a large allocation of energy, cyclical, and financial stocks – areas that would benefit from an inflationary environment.”

But there are also opportunities for income investors. “If you’re worried about the value of the dollar declining due to inflation, the last thing you want to do is hold cash,” cautioned Royal. “If you’re worried about rates going up, we would suggest taking an equal amount of credit risk and interest rate risk. Thrivent Opportunity Income Plus Fund (IIINX) includes a good deal of floating rate debt—leveraged loans – which tend to generate higher yields as market interest rates rise.”

Another area that Royal believes may also fare well in a rising rate environment would be limited duration bonds, such as those found in Thrivent Limited Maturity Bond Fund (THLIX).

Another option that may be well-suited for income investors would be Thrivent Multidimensional Income Fund (TMLDX). “It has more fixed income alternatives to drive yield, such as closed-end funds, convertibles, and preferred,” explained Royal. “So that would be a nice piece of the puzzle.”

He also suggests considering a moderately conservative allocation fund, such as Thrivent Diversified Income Plus Fund (THYFX), with about a 20% allocation to equities and a fixed-income allocation that seeks to provide more income than traditional bond funds.