Gavekal Capital: Inflation Expectations & Relative Performance

Tuesday, April 14, 2015

Inflation Expectations & Relative Performance

For about six weeks, between the middle of January and the first week of March, inflation expectations embedded in the US Treasury market bounced after declining for the second half of 2014.


With the double whammy of lower than expected US retail sales growth (now down under 1% year over year) and weak NFIB Small Business Optimism survey (down 5 points in the last month), bond yields are retreating today.  In the last four trading sessions, breakeven inflation expectations embedded in the 10 Year US Treasury bond are already down around 5bps and failed to eclipse the highs of early March.  It would appear market expectations of higher inflation have now reversed with the latest weak economy data points.

This is important for asset allocation considerations because counter-cyclical stocks tend to outperform when inflation expectations are falling and underperform when inflation expectations are rising.  In the charts below, we show the relative performance of MSCI World counter-cyclicals vs. cyclicals compared to US Treasury breakeven inflation expectations.



The relative performance of counter-cyclicals vs. cyclicals has an 85% correlation with 10 Year US Treasury breakeven inflation and an 82% with year breakeven inflation.  After a 6% relative outperformance of cyclicals from January 20 through February 20, they are now following the trend of breakeven inflation.  If bonds yields and inflation expectations continue to decline it would suggest the major trend of counter-cyclical outperformance will reassert itself.