View this email in your browser

Inflation Protection Model Portfolio

Monthly Portfolio Review: August 2024

Publication date: September 4, 2024

Current portfolio holdings

FOR SUBSCRIBER USE ONLY. DO NOT FORWARD OR SHARE.

Executive summary

• The Inflation Protection portfolio delivered a return of 0.8% in August, versus 2.4% for the S&P 500 Index.

• The modestly positive performance of the portfolio and the broader index obscures the fact that August was indeed a highly volatile month for stocks.

• Panic over a weak jobs report early in the month became elation over an expected Fed pivot on interest rates by the time Powell spoke at Jackson Hole on August 23.

• With investors worrying about a potential recession, commodity-related stocks underperformed. Gold was a notable exception, as the gold price edged up 2% in August, pushing all-time highs.

• The Fed is now shifting its focus from combating inflation to maximizing employment—and potentially committing yet another policy error that could ultimately benefit inflation-sensitive businesses and assets.

Performance review

The Inflation Protection portfolio returned 0.8% in August, versus the S&P 500 total return of 2.4%. Individual position performance ranged from -11% for Vulcan Materials (VMC) to 15% for Floor & Decor (FND).

Although the portfolio and the broader market produced a positive return for the month, the journey was quite erratic. Stocks sold off hard at the beginning of the month, following a weak jobs report, which was exacerbated by selling pressure related to the unwind of the Japanese yen carry trade.

Investors in the first week of August were panicking to an extent that the economy was quickly losing momentum and potentially dipping into recession, following two years of restrictive monetary policy.

Stocks would soon recover, however, as the Bureau of Labor Statistics issued a severe downward revision of its job creation estimates. This fueled anticipation of a Fed pivot towards interest rate cuts, which was confirmed by Jerome Powell when he spoke at the Fed’s summer symposium at Jackson Hole on August 23.

Today, the labor market has cooled considerably from its formerly overheated state…. The upside risks to inflation have diminished. And the downside risks to employment have increased….  The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. - Fed Chair Jerome Powell (8/23/2024)

Last month, and elsewhere, we discussed the profound impact that the Mag 7 technology platform stocks, especially NVIDIA (NVDA), have had on markets. These seven stocks now represent about one-third of the S&P 500.

The high representation of tech stocks within the index affects not only performance but also volatility. Tech stocks in general tend to have higher volatility and are typically “high beta,” meaning their fluctuations tend to be directionally consistent with market movements but are more extreme.

As markets weakened in early August, NVDA (which now has an approximately 6% weighting within the S&P 500) led the way down. NVDA fell more than 15% from the end of July through August 7—only to rally more than 30% from that low point by the time Powell spoke approximately two weeks later.

The unusually high volatility that we saw over the course of the month was reflected by a surge in the VIX Index early in the month. The VIX is perhaps the most widely referenced measure of market volatility—the more wildly the market fluctuates, up or down, the higher the VIX Index goes. The VIX spiked above 35 in early August—a level not seen since the market meltdown of 2022.

In August, higher volatility tech stocks underperformed as investors grew concerned over the health of the economy, which prompted a rotation into more defensive areas, such as Consumer Staples, Real Estate, Health Care and Utilities. Expectations of falling interest rates also provided support for these defensive sectors, which in many cases are viewed as “bond proxies” (stocks that are underpinned by stable long-term cash flows).

The macro sentiment shift that we saw in August generally did not favor inflation-sensitive sectors. With the Fed clearly pivoting towards a rate-cutting posture, interest rate sensitive sectors benefited. Commodity-related sectors mildly underperformed in the context of fears of an economic slowdown.

Gold rose modestly in August, up approximately 2%. This benefited the Inflation Protection portfolio’s gold streaming positions. Gold continues to hover around its all-time high of $2,500 per ounce, supported in part by anticipated interest rate cuts (along with other structural drivers like emerging market central bank purchases).

While gold functions as a long-term inflation hedge, declining interest rates favor the gold price as there is diminishing competition with interest-bearing investments. Put differently, the opportunity cost of owning gold rather than bonds declines as interest rates come down, making gold relatively more attractive.

Inflation outlook

The Fed is pivoting towards interest rate cuts because it has a dual mandate of maximum employment along with stable prices. It has pursued restrictive monetary policy to combat inflation, but now that labor market conditions appear to be worsening, perhaps considerably, the employment mandate is becoming more relevant—and potentially dominant.

With inflation still above the 2% target level (the July CPI increase was reported at 2.9%), the risk is that the Fed is easing before the inflation job is done. This could prove to be yet another Fed policy mistake, which could result in another inflation flare-up.

Alternatively, as many have speculated, the Fed may now be willing to tolerate structurally higher inflation rates above the 2% target level. In other words, in order to prevent the unemployment rate from spiking up, the Fed may bring rates down to levels that continue to generate elevated inflation.

If the deteriorating employment picture is causing the Fed to abandon restrictive monetary policy prematurely, this would tend to favor inflation-sensitive businesses and assets.

Portfolio highlights

Within the Inflation Protection portfolio, performance was led by Floor & Decor (FND), which returned 15%. Other top contributors were Costco (COST), which returned 9%, and TransDigm (TDG), which returned 6%. Detractors included Vulcan Materials (VMC), which returned -11% and Permian Resources (PR), which returned -6%.

FND shares gained momentum following the company’s second quarter earnings report in early August. As a retailer focused on home improvement and remodeling, FND has struggled this year given the housing environment but delivered positive signals of an improving business trajectory as mortgage rates begin to decline.

FND shareholders were also pleased to hear that the company intends to pursue a more focused expansion strategy. While the high interest rate environment has presented a headwind to FND, we continue to believe in the long-term value creation opportunity as a “category killer.”

COST had another strong month on the heels of a July interim sales update, in which the company reported net sales growth over 7%, including comparable same store sales growth over 5%. COST continues to demonstrate its ability to prevail in a highly competitive retail landscape by delivering great value for money in what has been a harshly inflationary environment. COST also benefits from targeting a relatively more affluent customer base than most retailers.

TDG shares performed well in August after a solid earnings print in which it nudged up full year earnings guidance. As a supplier of highly engineered after-market components to the aerospace industry, TDG continues to benefit from robust defense spending and a business model built around gradual long-term price increases for very specific products that face minimal competition.

VMC shares were down 11%, basically reversing their 10% gain in July. The share price moves largely reflect shifting sentiment towards cyclical names. Cyclicals benefited in July from a rotation towards industrial stocks but lost ground in August with emerging concerns over an economic slowdown.  

PR shares were down 6% over the course of the August, but rose 7.5% from August 5, when we increased PR’s weighting within the portfolio from 5% to 10% with the publication of the July monthly report. Energy was the only sector within the S&P 500 that delivered a negative return in August. We continue to favor PR as a long-term consolidation candidate with a very attractive footprint in the Delaware Basin.

Key metrics

Valuation detail

Performance detail

Company snapshots

Brown-Forman (BF.B)

Costco Wholesale (COST)

Freeport-McMoRan (FCX)

Permian Resources (PR)

TransDigm Group (TDG)

Visa (V)

Vulcan Materials (VMC)

Diamondback Energy (FANG)

Floor & Decor Holdings (FND)

Franco-Nevada (FNV)

Royal Gold (RGLD)

WESCO International (WCC)

Wheaton Precious Metals (WPM)

The 76research Inflation Protection Model Portfolio emphasizes business models that are expected to perform well on a relative basis in periods of elevated inflation. Holdings are typically selected from industries based on supply constrained real assets, including commodity and energy businesses, or companies that otherwise demonstrate superior pricing power. Drawing from an investable universe of expected inflation beneficiaries, specific holdings are chosen based on valuation and general business quality, growth and risk considerations. 

Disclaimer

FOR SUBSCRIBER USE ONLY. DO NOT FORWARD OR SHARE.