Inflation and the WisdomTree Model Portfolios

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Inflation seems to be on everyone’s mind right now. It is difficult to watch the news, open your laptop or pick up a newspaper or magazine without seeing stories and concerns about inflation.

We recently published a blog post discussing the drivers of inflation. In that post, we focused not just on the headline numbers (CPI, CPI ex-food and energy and PCE) but also on the numbers behind the numbers (wages and input costs). Let’s begin by looking at the current level of these various numbers.

First, the headline numbers:

The Federal Reserve’s (Fed) historical target rate was 2% (though it has adjusted to a more fluid “average inflation targeting” approach). Certainly, part of the dramatic increase this year is because of base effects—that is, inflation was zero at this point last year during the COVID-19 lockdowns, so the year-over-year increase is amplified. But we see a distinct upward trend.

How about the numbers behind the numbers? First, we will look at wages and personal income:

We are beginning to see an upward trend in wages as the economy reopens and employers, finding it difficult to find enough qualified workers, are raising wages to attract suitable employees.

Finally, how about input prices? (We will use the New York Fed’s numbers as a proxy for the nation.)

We see a dramatic increase in prices paid, the number of firms reporting higher input prices and — important for our inflation story — prices received (the purple line). Companies are paying higher input prices but increasingly passing those increases to their clients and consumers.

For now, the Fed suggests that these upward inflationary pressures are transitory, brought on by supply chain disruptions, the global pandemic, massive fiscal stimulus in the U.S. and huge pent-up demand by consumers as the economy finally reopens.

Perhaps, but we are not so sure. And, it seems, neither are some current Fed members, who have suggested that perhaps the Fed will have to revisit its hugely accommodative monetary policies sooner than was previously signaled.

WisdomTree Model Portfolio Positioning

As we’ve posted previously, two of our primary investment themes for 2021 and beyond are reflation and cyclical rotation. By cyclical rotation, we mean a factor and asset class rotation back to things that work best during a cyclical economic recovery—value and small cap in particular.

Our Model Portfolios have a variety of investment objectives. But they do have certain common characteristics, given the nature of most of the WisdomTree strategies we include in them. Unless asked to build custom models to meet firm-specific objectives, our models are:

• Global in nature

• ETF-focused to optimize fees and taxes

• “Open architecture” (will include both WisdomTree and third-party strategies)

• "Core-satellite” in their portfolio construction—that is, they will allocate to both cap-weighted and active factor-tilted strategies (size, dividends, quality, earnings, value, etc.)

• Diversified at both the asset class and risk factor levels to seek more consistent performance over full market cycles

In addition, we charge no strategist fee.

Cyclical Rotation

Since the announcement of the Pfizer COVID-19 vaccine last November, we’ve seen a strong cyclical rotation out of the large-cap, growth and momentum factors that led the market for years and back into the factors that historically performed best during periods of economic recovery: value and small cap (with the bonus of a nice rally in dividend-paying stocks).

Value and dividends:

Small cap:

The small-cap rally is equally visible in non-U.S. markets.

Developed international: 

Emerging markets:

Because of the nature of many of the WisdomTree strategies we deploy in our models, most of them have distinct and explicit tilts toward smaller-cap stocks, dividend-paying stocks and value-oriented stocks. Perhaps somewhat uniquely, we also have explicit allocations to international and emerging market small caps.

As such, our performance has benefited nicely from this cyclical rotation trend, which we believe will continue throughout 2021.

Reflation/Inflation

Here is an interesting chart illustrating the historical performance of different equity sectors under various inflation regimes:

We suggest we are in a “low and rising” inflation regime. Look at some of the asset classes and strategies that historically performed best in this regime—gold, commodities, EM equity, small cap and value. Those are exactly the factor tilts built into most of our models.

In addition, our Endowment model has explicit allocations to real assets, including gold, commodities, master limited partnerships (MLPs) and infrastructure, while our Siegel-WisdomTree Longevity model has explicit allocations to gold and commodities. Because the Longevity model is allocated 75% to equities, it may provide additional inflation protection, as stocks historically have been an effective hedge against moderate and increasing inflation.

Conclusions

Two of WisdomTree’s primary investment themes for 2021 and beyond are cyclical rotation and reflation. We are witnessing both themes play out in full force so far this year.

It is always nice to have market winds at your back rather than in your face, but we believe our portfolios are (1) well-positioned to take advantage of these current winds while (2) remaining diversified at both the asset-class and risk-factor levels so that they may stay upright and afloat, regardless of which way the winds blow.

Financial advisors registered on the WisdomTree website can learn more about our Model Portfolios on the Model Adoption Center.

For definitions of indexes in the chart, please visit our glossary.