Authored by Simon White, Bloomberg macro strategist,
Trades favoring disinflation are soon set to reverse as price increases prove more entrenched than anticipated.
This year, higher-duration sectors, such as tech, telcos and consumer discretionary have led stocks’ advance, while low-duration ones such as energy and utilities have underperformed. This is a reversal of the trend from late 2021, where investors started to shun high-duration stocks as inflation began to rise rapidly.
Duration is the ultimate driver of investor preferences in an inflationary cycle such as the current one. This year growth has begun to outperform value again, and cyclicals are outpacing defensives, but these obscure the bigger picture of how long-duration assets are best avoided when inflation risk is high.
Investors re-embracing higher-duration stocks is a signal they are also embracing the disinflationary narrative, one endorsed by the Fed and priced in to inflation swaps.
That narrative may soon run into trouble though. Headline inflation is falling, but this is almost all due to the drop in cyclical inflation. We can estimate cyclical and structural inflation by looking at the sub-components of CPI that are persistently above trend (structural) and those that are not (cyclical).
The chart below shows that while cyclical inflation has fallen, structural inflation is barely off its peak.
What is likely to happen is that cyclical inflation will keep falling in the near term, taking headline CPI lower. But structural inflation will remain stubborn, meaning CPI will make a higher low. At this point, cyclical inflation will begin rising again, taking headline inflation with it.
This would be a rude awakening for tech and consumer discretionary and other high-duration sectors that have risen this year.
The bigger trend of lower-duration sectors outperforming – encapsulated in the energy vs tech stock rotation – is likely to re-assert itself sooner rather than later, taking the market lower with it.