Day Hagan Research Update

DAY HAGAN RESEARCH UPDATE

ETFs AND INFLATION SENSITIVITY

SUMMARY

Several measures suggest that we are due for a significant increase in inflation.

WRITTEN BY

Neil Leeson

POSTED

January 20, 2017

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As the expectations for economic growth have accelerated since the U.S. election, so has the expectation for a significant and sustained increase in inflation, albeit from very low levels. Despite bouts of quantitative measures, low interest rates, and stimulative policies by the Fed since 2009, inflation and U.S. growth expectations have barely budged. Nonetheless, expectations for future growth and supply-side inflation (increase in prices of production inputs) have changed significantly with the new U.S. political administration's plans to increase infrastructure spending alongside higher energy prices. If we can "expect" the U.S. economy to grow faster than it has over the past eight years, we should also expect to see an increase in inflation, and shift our investments accordingly. But like any other market or macroeconomic scenario, we continue to act on what is happening, not what should be happening.

Ned Davis Research Group has developed an inflation timing model (below, bottom clip) based on 22 individual indicators that gauge the changes in industrial production and commodity, consumer and producer prices. As shown, the model is signaling high inflationary pressure which is typically a negative for bond prices.

EQUITY ETFs AND INFLATION

Historically, ETFs tied to the Energy sector have the highest positive sensitivities to increasing inflation measures, because energy components are part of the CPI calculation, and when energy prices rise, energy companies typically benefit. This high sensitivity also goes for country ETFs that are weighted towards the energy sector (and the banks tied to those businesses) like Brazil, Russia and Canada. These are a few of the international ETFs that we are monitoring for possible allocation in the future.

XOP, the SPDR S&P Oil & Gas Exploration & Production ETF, has one of the highest sensitivities to inflation expectations historically.

Outside of energy sector ETFs, the next highest sensitivities are found in the material and mining ETFs. Those companies that will supply the raw materials for infrastructure projects benefit directly from an increase in commodity prices. Inflation expectation sensitivity for XME, the SPDR S&P Metals & Mining ETF, has increased of late from an already elevated level.

It is clear that sector-specific funds tied to raw materials have had historically high sensitivity, and there are several examples in those categories. But there are composite equity ETFs that have done well in inflationary environments. Somewhat surprising, that in the long run, high beta and high dividend funds have also done well as expectations of inflation increase. Most of those funds have exposure to the energy and raw material sectors, but not a dominant amount over other sector allocation.

U.S. DOLLAR, RISING RATES AND INFLATION

The Fed typically increases interest rates or tightens monetary policy to cool down the economy and inflation. While the current Fed environment may be to "normalize" rates and not slow inflation, higher rates will still impact prices. One side effect of higher prices and a steeper yield curve is a stronger U.S. dollar. If you add the stronger dollar as a caveat, meaning you want funds with positive sensitivity to a stronger dollar, increased inflation and a steeper yield curve, energy and material companies drop out of the conversation.

The Financials sector, and particularly regional banks, have historically been the only major sector to respond positively to all three conditions. But there are broader-based funds that have historically performed well in this environment, such as small-cap value, small-cap dividend, mid-cap earnings and mid-cap value funds. We currently have allocation to these areas, and are looking to increase our exposure once long-term overbought conditions are worked off (looking for a pullback).

As shown below, IWN, the iShares Russell 2000 Value ETF, has reached extremely overbought levels based on historical mean reversion measures. While the underlying trend and breadth are supportive of further strength in IWN, this chart suggests that the ETF has gone too far too fast and that a reset is in order.

Bottom Line: Many ETFs that do well in the current and the expected environment are in the same overbought situation as IWN. We are looking to add to our exposure in these areas, but not at current prices.

Have a wonderful week,

Neil Leeson
Day Hagan Investment Committee Consultant
Day Hagan Asset Management

Written 1.19.2017

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