With inflation spiking and interest rates rising, David Royal, Thrivent Chief Investment Officer, and Steve Lowe, Chief Investment Strategist, recently tackled some of the key questions facing the market during this turbulent time.

Inflation has jumped to the highest levels since the early 1980s, roiling markets and hitting consumers’ pocket books.

“After being dormant for years, inflation has really surged,” explained Lowe. “But the Fed really struggled to recognize the persistency of inflation, and now they find themselves behind the curve. As a result, they have to play catchup, which means they have to raise rates relatively quickly. That has left the markets struggling to forecast how the steepest and quickest hike cycle since the 1990s will affect the markets.”

Lowe added that inflation “was fueled by the growing demand for goods, like technology, cars, and houses, and then we had shortages disrupt supply chains, which created a perfect storm of inflation. Recently we’ve seen it seep into other areas like wages, which is a little more concerning and one of the drivers of persistent inflation.”

The Producer Price Index (PPI), which is commonly used as an inflation gauge, has been running between 9 and 10%, while consumer inflation has risen by about 7% over the past year, driven by strong demand, goods shortages, and rising commodity prices, such as gasoline. The rise in prices not only affects consumers, but it impacts corporate earnings, as well.

“As you move into that recovery phase,” he added, “it can be a little counterintuitive. The types of stocks that tend to perform well in that phase are the areas that nearly went under a few months earlier – the riskiest stocks, cyclicals, deep value, high beta, low quality companies with high leverage, negative earnings, or poor credit ratings, including small and even micro caps – and we saw that in spades in the first quarter of 2021.”

The economy very quickly moved out of that recessionary phase into the recovery period. “The recovery period is when the economy is still growing but growth is decelerating, and inflation is picking up,” said Royal. “At that stage of the economy, you may want to be in some higher quality names but still cyclical value, defensive value, and areas with growing earnings. You may also want to move up in market capitalization during this period. As you’ve seen over the past nine months, small caps haven’t done anything.”

Entering a slow-down phase, Royal believes investors should move to the higher quality, growth momentum, longer duration segment.

“Think big cap tech. That’s where FAANG is really going to shine – moving from value to growth. Right now, the correlation between growth and value is about as low as it ever gets, meaning growth and value are kind of trading back and forth as the market tries to figure out where we are in this expansion. As we see signs of economic slowdown – and we will at some point – that’s when you would want to move toward large cap names – like growth and technology. And then to finish the circle, you would want to get a little more defensive as you start to see the economic slowdown progress and perhaps even accelerate.”

The recent market sell-off was led by small and mid-cap stocks, many of which dropped 40% or more. “I view periods like this as an opportunity to buy great growth-oriented companies that are going to benefit from the next phase of the cycle because the sell-off was so indiscriminate,” said Royal. “The types of quality companies we want to own are those that have little or low profits because they’re growing their business and have a good business model that would allow them to switch to profitability almost any time they want.”

Where to turn

“The market may decline during a Fed hiking cycle – which usually occurs during a good economy – but those tend to be buying opportunities,” said Royal. “The market rarely goes into a severe bear market unless the economy goes into a recession. And there is nothing in the economic data to suggest that we’re entering a recession in the next few quarters.

“If the Fed gets more hawkish,” he added, “and we see the market sell off as a result, I think we would be adding equity.”

But there are also opportunities for income investors. “If you’re worried about the value of the dollar declining due to inflation, the last thing you want to do is hold cash,” cautioned Royal. “If you’re worried about rates going up, we would suggest taking an equal amount of credit risk and interest rate risk. Thrivent Opportunity Income Plus Fund (IIINX) includes a good deal of floating rate debt—leveraged loans – which tend to generate higher yields as market interest rates rise.”

Another area that Royal believes may also fare well in a rising rate environment would be limited duration bonds, such as those found in Thrivent Limited Maturity Bond Fund (THLIX).

Another option that may be well-suited for income investors would be Thrivent Multidimensional Income Fund (TMLDX). “It has more fixed income alternatives to drive yield, such as closed-end funds, convertibles, and preferred,” explained Royal. “So that would be a nice piece of the puzzle.”

He also suggests considering a moderately conservative allocation fund, such as Thrivent Diversified Income Plus Fund (THYFX), with about a 20% allocation to equities and a fixed-income allocation that seeks to provide more income than traditional bond funds.  

For equity investors in a high inflation environment, Royal suggests investing in a fund such as Thrivent Large Cap Value Fund (TLVIX), “which holds a large allocation of energy, cyclical, and financial stocks – areas that would benefit from an inflationary environment.”