Perhaps the biggest story of 2014 for U.S. investors is the return of the inflation trade as U.S. inflation rates as measured by the Consumer Price Index (CPI) have bottomed and accelerated over the last few months. Rising home prices and rental rates are closely tied to inflation and were projecting a turnaround in the CPI starting this year and into 2015, as I showed in January with the following (click here for article):
The one negative thing to keep in mind about housing is that it represents roughly one third of the Consumer Price Index (CPI) and housing prices tend to lead owner’s equivalent rent by more than a year. As seen in the image below, the owner’s equivalent rent component of the CPI Index is set to begin rising this year and accelerate into 2015. This will be an important watch point going forward.
An update of the chart above shows that we aren’t likely to see a peak in rental inflation until the fall of 2015, which suggests higher inflation will continue and the recent rise is unlikely just "noise".
The acceleration in the CPI index projected at the beginning of the year is readily visible when viewing the monthly pickup in inflation rates since February.
The Inflation Trade – Long Energy, Short Consumer Discretionary
In my last article, “Countdown to Another Market Peak Has Begun,” I highlighted the importance of inflation on the business cycle in a world of ZIRP (zero interest rate policy). Given the importance of inflation on the business cycle and investment returns, it should come as no surprise that this recent pickup will play a major role in sector rotation this year. One of the most visible influences of inflation on sector returns is in the relative performance of the energy sector versus the consumer discretionary sector.
The disparity between the two sectors is readily visible when looking at market stats for this year where the S&P 1500 Energy Sector is up 12.68% year-to-date (YTD), while the S&P 1500 Consumer Discretionary sector is down -1.05% YTD and the only sector down for the year.
While the S&P 1500 Energy sector leads the market with the most members that reached 52-week highs this week at 56%, the S&P 1500 Consumer Discretionary sector tops the list in most 52-week lows over the this week at 1.03%.
Looking at money flows amidst the major SPDR sector ETFs shows more than .3B of outflows from the Consumer Discretionary ETF (XLY) while the energy sector has seen more than .1B in inflows, making the inflation trade (long energy, short consumer discretionary) the most dominant sector theme of the year.
It’s Not Just Housing Leading to a Pickup in Inflation
While housing has played a key role in moving the inflation needle higher, so too has an improving economy that has since thawed from the winter chill. The Bloomberg Economic Surprise Index rests at the highest level since early 2013 as we’ve had a string of positive surprises since February, which is also when the CPI began to accelerate.
This week was no different as the majority of economic releases beat expectations while housing-related indicators came in soft.
Accelerating Economy Leading to Improving Stock Market Strength
While the pickup in the economy is strengthening the inflation trade, it has also strengthened the overall market as we’ve seen significant improvement in the market’s trend and momentum. All time horizons for the market are now back into bullish territory.
* Note: Numbers reflect the percentage of members with rising moving averages: 200-day moving average (or 200d MA) is used for long-term outlook, 50d MA is used for intermediate outlook, and 20d MA is used for short-term outlook.
While the S&P 1500’s momentum (as measured by the MACD indicator) does not quite have a bullish outlook for all time frames like its trend strength, we did see the market’s weekly momentum pickup and is only 2% away from moving into bullish territory with its current 58% reading—a big increase since the 34% reading seen in early May.
Another encouraging development is that weekly MACD buy signals have broken their downward trend and are now moving higher.
Economy Should Continue to Accelerate over the Coming Months
We should see continued improvement in the market with further expansion in the economy, as highlighted by this week’s June release of the Philadelphia Fed’s Business Outlook, which came in at 17.8, well above the consensus of 14. In the report we saw a big jump in capital expenditure plans over the next six months, which bodes well for the investment component of GDP.
There was even more encouraging data from the special questions section of the report which showed that 74% of firms surveyed expect production to increase in the second half of the year while 56% saw not only an increase in production levels but an acceleration of growth compared to the first half of the year. Of those that are expected to increase production, one third said they would do so by adding to their payrolls (new hires) versus just extending the work week. This is a sign that business confidence is picking up.
Source: Philadelphia Fed
Summary
Perhaps the most dominant market theme of this year is the return of the inflation trade as investors pour into the energy sector with funds raised by liquidating their allocation to the consumer via the consumer discretionary sector. Given the forecast in continued rental inflation well into 2015 we should continue to see a bid under the inflation rate throughout this year and the relative performance of the energy sector relative to the consumer should continue.
While inflation is seeing a boost coming from prior housing inflation, we are also seeing a pickup in inflation coming from an accelerating economy in which economic releases continue to surprise to the upside. This is leading to a broadening out of participation in the rally as measured by improving trend and momentum for the S&P 1500.
Economic growth is expected to continue to improve based on the message from various leading economic indicators and the tough job for investors ahead will be to gauge when inflation rises too far and too fast and begins to hurt the economy and the market. This will be a topic covered next week.
