AIQVM Positioned Better for Inflation Risk than SPX & SPXEW
March 20, 2018
The Federal Reserve Bank (Fed) began its current series of rate hikes on December 14, 2016. The Fed raised its Federal Funds Rate three times in 2017 and we anticipate it will make its fifth 25 basis point (0.25%) hike on March 21, 2018. Investors expect three to four additional 0.25% rate hikes based on the Fed's concern about higher inflation risk and its goal of getting the Fed Funds to a "reasonable" premium over annual inflation, which currently is 2.1% (bottom of Figure 1). The S&P 500 Capitalization Weighted Index (SPX) has a total return of 21.9% while the Arrow Insights Quality Value Momentum Index (AIQVM) and the S&P 500 Equal Weight Index (SPXEW) posted returns of 20.9% and 16.6% respectively from December 14, 2016 through March 16, 2018 (Figure 1).
AIQVM's multi-factor process selects 50 equally weighted U.S. stocks. As of February 28, 2018, AIQVM was positioned to hedge inflation risks better than SPX and SPXEW due to its overweight (OW) allocations to sectors that perform best when annualized inflation rises and remains above 2.5% namely, the consumer discretionary, industrials and the basic materials sectors. AIQVM currently is underweight (UW) utilities, consumer staples and real estate, which perform best when annual inflation is falling and remains below 2.5% (Figure 2). These sectors hold a strong correlation to high quality bonds.
Figure 1. AIQVM Bests SPX & SPXEW as Rate Rise – Mar 31, 2016—Mar 16, 2018
Sectors with strong correlations to bonds hedge deflation risk (negative inflation rates) better than inflation risk. The right–hand columns in Figure 2 list the differentials in sector weights between AIQVM–SPX and AIQVM–SPXEW.
Financial and technology stocks hedge inflation and deflation risk, absent a severe depression and are thus shaded in grey. The label "Mixed" was employed because AIQVM was UW both technology and telecom relative to SPX while AIQVM was OW these sectors relative to SPXEW.
AIQVM's factors recently selected stocks that potentially hedge rising inflation risks better than SPX and SPXEW. Consequently, AIQVM might best these indexes as the Fed hikes rates.
Figure 2. AIQVM Positioned Better for Inflation Risk than SPX & SPXEW – Feb 28, 2018
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