- Inflation has shown few signs of slowing down, and that realization has crushed market confidence.
- Neil Azous, CIO of Rareview Capital, has an inflation-focused ETF that has held up well.
- Here are four tips for navigating this choppy stock market as recession risk mounts.
Investors were hit in the stomach this week after a report revealed that inflation has yet to peak month-over-month.
But during the subsequent liquidation, the worst in over two yearsthe Rareview Inflation/Deflation ETF (FLTN) barely moved. In fact, the fund is down just 0.2% last week and just 4.7% since its inception on January 6, which is several percentage points better than its indexaccording to Morningstar.
A strategy that evolves along with inflation
Neil Azous, the founder and CIO of Rareview Capital, runs the inflation-focused fund. In a recent interview with Insider, he described how the fund has benefited greatly from its “somewhat agnostic” relationship with benchmarks and indices like the S&P 500.
Rather than track an index, Azous’s goal is for the fund to outperform the rate of price growth by determining where the economy is in the inflation cycle and responding accordingly.
“It’s an active management approach to US interest rates, that’s the key here,” Azous told Insider. “Most people who have fixed income in the US have it as a risk-free asset, not necessarily as an income-producing asset, but more as a balance in a 60-40 portfolio.”
Azous continued, “In our case, what we’re trying to do is take that kind of forgotten piece in a core portfolio and replace it with an active solution. So provide something similar to the downside but have potential for the upside.” “
Inflation is currently in the mid to late cycle stage, Azous said, as measured by the extreme level of interest rates that the markets are trading in. Fittingly, the Federal Reserve is halfway through its monetary tightening cycle and has now moved above a neutral rate, Azous said.
In response, the ETF manager followed his own advice and bought breakevens like Treasury Inflation-Protected Securities (TIPS) earlier in the year, but has since moved on to buying US Treasuries.
Prepare for more losses
Staying nimble is necessary as both inflation and the economy change, Azous said. The investment chief warned of more trouble ahead for US equities as the Fed rapidly raises rates in a desperate bid to rein in inflation, even if doing so could cause a recession.
“The Fed is getting to a point now where they’re just going to break the markets,” Azous said. “That’s what they do. They use a blunt instrument, they move through various regimes, they test it as far as they can go. And the way they know they crossed the line is they broke the market. And for us, that leads to a lower stock market and a tougher credit market or much tighter financial conditions. And that’s where they are at this crossover.”
But the US central bank’s “forceful and aggressive” approach to bringing inflation back under control is not a mistake, Azous said. A recession may happen, but he believes the alternative would be worse.
“The bottom line is you can’t have a strong job market and a strong economy unless you tame inflation and get it under control,” Azous said.
Azous added: “It’s about absorbing short-term pain for long-term gains,” Azous said. “Because if you don’t absorb it, there won’t be any long-term gains.”
Although inflation remains frustratingly high, Azous said “the Fed is winning at what it’s trying to accomplish,” adding that there is now a “light at the end of the tunnel” for the interest rate hike cycle.
However, the Fed’s curbing of inflation won’t be much comfort to investors if earnings collapse.
“The longer inflation remains entrenched in the system and the longer interest rates remain high, the more pain it will cause for corporate America,” Azous said. “And that should lead to incremental earnings deterioration.”
Azous said he sees the S&P 500 falling as much as 18.5% from current levels to 3,200-3,400 due to a combination of risks: falling earnings and valuations, as well as tax-loss sales. He noted that if the S&P 500 falls to the levels he expects, it would be a 33.5% drop from the index’s all-time high, which is in line with previous bear market sell-offs.
Barring a catalyst such as the end of the Russian-Ukrainian war, a noticeable improvement in the Chinese or European economies, or a big drop in inflation, Azous said he sees more trouble ahead.
“In the absence of those positive catalysts, I think we can hit the lows of that stock market or below the lows of the year between now and the end of the year,” Azous said.
4 tips for successful investing
More turmoil may be ahead for equities, but investors shouldn’t just give up. Azous shared four investment tips for managing inflation and bear markets.
First, the manager of the inflation ETF told extend the maturity of the bonds in a portfolio. This means favoring 5-, 10- and 30-year US Treasuries over their shorter counterparts as inflation moves toward the end of the cycle and the Fed eventually stops raising rates and even lowers them.
Then Azous said it is vital keep “24-hour liquidity” available during periods of uncertainty. This can come in the form of investments that are easy to get out of, which, in fact, it’s not trash.
“You want to avoid a catastrophic drawdown that keeps you invested in the stock market,” Azous said.
On a similar note, Azous’s third tip is take sound risks. Making a definitive call on growth stocks or value names is a risky proposition that is difficult to do accurately on a consistent basis, she said. Another mistake would be to buy options, in his opinion, given their risk-reward prospects.
“I have a very strong background in derivatives, including buying and selling put options,” Azous said. “The reality is that the option bias does not have a high enough payout ratio to warrant you buying a short put option, which means it will cost too much at this stage. That ship has sailed.”
Finally, Azous said that investors who agree with his view that there is much more room for the S&P 500 to fall should be underweight stocks, or sell them short entirely. Only veteran traders should consider the latter, Azous said, given the potential for big losses in doing so.