Don't tell Wall Street but if you want to get your portfolio positioned for our U.S. economic outlook buy Technology (XLK) and Consumer Discretionary (XLY) stocks. Here's why.
We find two factors to be most consequential for forecasting future financial market returns: economic growth and inflation. We track both on a year-over-year rate of change basis to better understand the big picture then ask the fundamental question: Are growth and inflation heating up or cooling down?
From there, we get four possible outcomes, each of which is assigned a “quadrant” in our Growth, Inflation, Policy (GIP) model and the typical government response as a result (neutral, hawkish, in-a-box or dovish): Growth Accelerating, Inflation Slowing (QUAD 1); Growth Accelerating, Inflation Accelerating (QUAD 2); Growth slowing, Inflation Accelerating (QUAD 3); Growth Slowing, Inflation Slowing (QUAD 4).
After building this base of knowledge, we can now select what we like and don’t like based on our historical back-testing of the different asset classes that perform best in each of the four quadrants. Our GIP model suggests that the U.S. economy is currently in Quad 1 for the second quarter of 2017 and should remain there through the first quarter of 2018. This has historically been the best environment for domestic equities.
What Assets Work Best With U.S. Growth ↑, Inflation ↓?
If you're looking to tilt your portfolio to Quad 1 asset classes. The top-performing S&P 500 sectors historically when U.S. growth is accelerating and inflation is slowing are Technology (XLK) and Consumer Discretionary (XLY). Specifically with respect to the trailing 20 years of quarterly observations, Consumer Discretionary and Tech have positive expected values of +4.4% and +4.0%, respectively, in Quad 1 (i.e. GROWTH ↑; INFLATION ↓), which are the first and second best return profiles across the ten GICS Level 1 sectors.
So basically, get the direction of U.S. growth and inflation right and you get portfolio overweights and underweights right. This is a reliable framework. This year Tech and Consumer Discretionary are among the top performers, up +15.4% and +11.6% respectively and ranked #1 and #3 by year-to-date performance. Note: These numbers are inclusive of the recent Tech "rout."
One Last Piece of Advice...
As Hedgeye CEO Keith McCullough writes in today's Early Look, "Remember the ABC’s of how Hedgeye thinks about Global Macro:
A) “Expensive” macro exposures get more expensive
B) And “cheap” macro exposures get cheaper
C) Provided that the prevailing direction of growth and inflation TRENDs don’t change"
Put another way, it's accurate measuring and mapping of the U.S. economy that helps investors realize outsized returns. It's a more reliable framework than relying on more traditional investing frameworks, like valuation. It's U.S. growth accelerating and inflation slowing down that matters for your portfolio right now. That's why expensive Tech and Consumer Discretionary stocks have been getting more expensive.
