I drive a car with a manual transmission. When I have full control over all components of the car, it makes the driving experience much more exciting for me.

I've often associated this gear shifting with markets. Bull markets run through a series of gears, or states, as they move through their complete cycle. The same is true for bear markets. Sometimes, these gear shifts can completely change the beliefs of both markets and the economy; at other times the changing of gears is more subtle.

In my view, a gear shift occurred on February 2, with the release of the January non-farm payroll report. In other words, the market finally took notice of building inflationary pressure when the monthly wage inflation and strong job-growth figures were released. Since this inflection point, the market has been in a tug of war between growth and inflation, resulting in bouts of volatility. In our opinion, this tension will likely contribute to market choppiness in the months ahead, a 2018 theme highlighted in my January update.

It is incredibly important for investors to understand and appreciate this shift in gears in order to successfully navigate the next phase of this bull market cycle.

Evidence of the Shift

The new yield range of the 10-year Treasury note shows that the markets are now starting to focus on inflation. Following the January jobs report, the 10-year Treasury note spiked roughly 50 basis points and has settled near 2.8%. While some thought the move in rates was an overreaction, the 10-year note has remained stuck in a new, higher range despite plenty of excuses to move lower. This reluctance of yields to move lower could be a sign that either higher inflation or stronger growth, or both, are in the works.

Defensive sectors, such as consumer staples and utilities, are known for their low volatility, recession-resistant characteristics. However, both have been underperforming the broader S&P 500 during this recent pullback. In fact, the consumer staples sector is the poorest performing sector year to date. To uncover why these sectors are not fulfilling their traditional role of playing defense, we need to take a deeper look under the hood to see what's going on.

Our friends at Leuthold Group recently presented some data that got my attention. In looking at the consumer staples sector going back to 1928, they found that the sector's performance can be analyzed by comparing two measures of inflation. Specifically, as illustrated in Exhibit 1, they analyzed the spread between the consumer price index (CPI) and the All Commodities Producer Price index (PPI) using a five-month moving average. They noted that, over the past 90 years, the consumer staples sector produced all of its outperformance relative to the S&P 500 index in periods of time when the CPI was greater than the PPI.

Exhibit 1. Under the Hood of Consumer Staples

*Consumer Price index – All Urban Consumers to Producers Price index – All Commodities. Analysis for 1928 to February 2018 Source: The Leuthold Group

A CPI/PPI ratio provides a glimpse into profit margins. The consumer staples sector thrives when the cost of producing goods falls relative to the price they are sold for, but struggles when the opposite is true. Recent data show that the CPI/PPI ratio is currently negative, which explains why the sector has underperformed the overall market so far this year. This defensive sector even underperformed in the most recent correction — the first time since this bull market began. In corrections dating back to 2009, the consumer staples sector has fallen by only about one-third of the overall market. I believe inflation is the reason the sector is behaving differently right now.

Higher production prices eventually make their way through the economy. Firms can pass along higher costs to the end consumer or they can accept lower profit margins. Higher consumer prices may be a long way off, but inflationary pressures are beginning to brew under the hood.

Markets Are Coming Around to Our Point of View

Inflation, in my opinion, is the most important variable regarding markets and the economy. As I've noted in recent speaking and media opportunities, the market is finally beginning to see that rising inflation is a distinct possibility. We have had rising prices on our radar since late 2016 and have positioned client portfolios for this outlook with a modest overweight to equities, an underweight to fixed income and the inclusion of diversifiers. In other words, do not expect us to make major asset allocation changes, as this shift in gear is a natural progression and one that we have anticipated. So, although I still believe the market and the economy remain in a mid-cycle bull market, the market's focus on inflation suggests we are approaching the next part of the cycle.

Going Forward

The Fed has set a target rate of inflation at 2% and focuses on the personal consumption expenditures (PCE) price index as its measure. At this level, prices are steady enough to increase consumers' wages and stimulate spending, while at the same time encouraging businesses to invest. But if prices increase too quickly, the Fed may have to raise rates more quickly than is currently anticipated in order to combat inflation. Historically, this has played a role in ending bull markets.

The good news about inflation is that we expect only a modest increase this year. The labor report released in early March and the Fed's decision on March 21, 2018 to raise short-term interest rates 25 basis points seems to corroborate this view. Specifically, the March labor report moderated many inflation fears, while leaving the employment rate flat at 4.1%. Although the rate hike was highly anticipated, the Fed illustrated that they were increasing their growth outlook, but did so with only modest inflation projected going forward. The latest wage growth figures released in April's jobs report should also support a gradual pace of tightening.

Other factors such as tariffs, trade, currency moves and further changes in fiscal policy could influence our views on inflation and warrant monitoring on a daily basis. But the underlying variables of interest rates and inflation are at the core of our decision-making process, and all other inputs will be viewed through the lens of how they will impact these key variables.

Inflation, through this shifting of gears, now has the market's attention. Although we only see a drift higher in inflation, mounting pricing pressures could be a headwind for the market this year. For now, we think global equity markets will power through, backed by strong earnings and a patient Fed. But investors should expect a more volatile ride as the market settles into to this new gear, and the new dynamics it may hold.

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