How Do We Seek to Mitigate Equity Risk During the Market’s Inflation Fixation?

For the first time in many investors’ careers, the market has developed an inflation fixation. Stocks have been volatile in recent weeks, trending down on any bit of news that suggests prices are rising too fast.

We remain in the camp that believes these concerns are overdone. But we are not tone deaf to the market’s inflation fixation when it comes to hedging equity risk in our long/short portfolios. This blog looks at how we are implementing it.

Our base case is that inflation is still tame

Today the consensus anticipates an economic boom with the return of inflation being the possibly inevitable consequence. We have no doubt the employment recovery will be fast and with the checks from the second federal stimulus program in the bank and a new $2.3 trillion infrastructure investment program on the shelf, the economic boom scenario only looks more likely.

The base effect caused by falling prices during the pandemic will make year-to-year inflation numbers this spring look like we are going back to the 1970s. But we believe that is likely to evaporate in the second half of the year.

Commodity prices have indeed risen in recent months, but these prices rise because a demand surge happens before supplies can be brought on. Shortages of industrial and agricultural commodities are widespread today but eventually supply and logistical bottlenecks will be resolved and price pressures relieved.

China serves as an example of what the coming months could look like. The country was the first economy to recover last spring and its needs for industrial materials soared, but it has now reportedly rebuilt its inventory stocks.

Over the long term, there are also powerful secular forces that we think will limit spending and inflation pressures. These include demographics (a population that is getting older and saving more), already heavy consumer balance sheets and technology, which is driving production costs down.

Inflation fears are still a risk to equity markets

While we believe runaway inflation over the long term is unlikely, concerns about rising prices still have a grip on markets, and the inflation fixation is probably one of the biggest risks to stocks in the short term. As such, we are actively looking to hedge against it.

For those unfamiliar with our investment process and philosophy, we believe it is absolutely critical to hedge equity risk in long/short strategies. Our view is that if these strategies don’t hedge equity risk effectively – and sometimes creatively – a manager is at risk of being forced to sell the portfolio’s best long positions at precisely the wrong time. With that in mind, we are pinpointing how we hedge against an equity market downturn when Wall Street is fixated on inflation.

One way we are currently seeking to hedge that risk, where and when we think appropriate for our clients’ portfolios, is by shorting a few industry specific exchange traded funds (“ETFs”) that represent baskets of high growth, highly valued stocks. In our view, these are the pockets of the market that would be most penalized in a sell-off driven by inflation concerns. The reasoning is roughly this: If the market believes inflation is out of control, it will also anticipate rising interest rates. As rates move higher, it lowers the present value of a future stream of earnings. This disproportionately affects nascent, growth companies, whose greater potential earnings are further in the future.

Since these stocks are most acutely affected by rising rates, we believe shorting ETFs tied to stocks in these industries is one approach that can be a cheap, effective hedge against a downturn in equities that is driven by fears of inflation.

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