Investing is about expectations. Think of situations where a company’s earnings-per-share (EPS) are reported in line with the consensus. Nothing much happens. But, how about when EPS comes in below expectations. Carnage is usually the result. A nice bump in the share price usually follows an EPS release that exceeds the forecast.
Investing is also about change. EPS numbers might have been heading in the right direction, but reversed course, forcing investors to rethink their expectations and positions. Reality changes, and expectations about the future change as well.
If we move from individual stocks to economies and markets, then EPS numbers start to lose their relevance, except when considered on aggregate. But, there are two key variables, which really do set the tone.
Growth and Inflation
The two key variables are:
- Inflation: The rate at which the general price level of goods and services in an economy is increasing over time. This is typically measured by an inflation index, such as the Consumer Price Index (CPI).
- Growth: The rate at which an economy is expanding, typically measured by Gross Domestic Product (GDP).
Two variables, that can either be rising or falling give four states, quadrants or regimes. Investors might select different asset classes depending on which regime is in play, and perhaps more importantly which regime they believe is coming. Thus regime shifts can be seismic investing events as they prompt money to flow from say stocks to bonds, or vice versa.
You might be wondering why interest rates are not one of the variables. Well, this four-quadrant framework is not my own. It was popularized by Ray Dalio of Bridgewater Capital and is widespread in financial-themed curricula. I encountered in during my CFA studies. Interest rates can certainly be relevant when making investment decisions. But this framework’s argument is that they are indirect variables. Central banks have mandates to maintain inflation at some level. Sometimes they also attempt to keep unemployment as low as possible.
Interest rates do affect growth and inflation, but they are usually changed in response to changes in growth and inflation. Each of the four regimes is associated with hawkish or dovish monetary policy, and also fiscal policy. So, leaving them out as direct variables does not significantly impact the usefulness of what is intended to be a relatively simple framework.
Ray Dalio’s four-quadrants
Ray Dalio, of Bridgewater fame, says that looking at whether inflation is either rising or above expectations, or falling or below expectations, and doing the same with GDP and thus, forming four quadrants. These are commonly called goldilocks, reflation, deflation and stagflation.
Readers might be familiar with the notion of risk-on and risk-off. Well, risk-on is associated with goldilocks and reflation regimes. Risk-off attitudes pair nicely with deflation and stagflation.
| Growth | Inflation | Investment Environment |
| Above expectations/rising | Below expectations/falling | Goldilocks |
| Above expectations/rising | Above expectations/rising | Reflation |
| Below expectations/falling | Below expectations/falling | Deflation |
| Below expectations/falling | Above expectations/rising | Stagflation |
The point of a simple framework is to make decisions easier. Mr Dalio likes to build All Weather portfolios by allocating 25% of his capital to asset classes that historically have performed well in the conditions that define each of the four quadrants. But if we limit the conversation to just stocks, then there are certain sectors and industry groups that should do better in each of the environments.
Cyclical, sensitive and defensive stocks
I like Morningstar’s approach of rolling up the traditional sectors into three categories based on their relationship to the business cycle which also corresponds quite well to the four-quadrant framework.
Financial, consumer cyclical, real estate and basic materials stocks are bundled together as cyclicals. Consumer defensive, healthcare and utility sector stocks are defensives. And finally, there are the sensitive stocks which are from the telecoms, energy, industrial and technology sectors.
In the Goldilocks region, I would lean into the sensitive stocks which include growth stocks, tech stocks and the like. In a reflation regime, I would look towards cyclical stocks, like commodity-producing miners, which benefit from economic growth and higher prices of their products.
Deflation is a tricky quadrant but defensives stocks and in particular ones that pay a safe, steady dividend. Stagflation is even trickierer to navigate. Gold miners might be an idea as the price of gold usually increases. Stock in any company that produces the thing that is driving inflation is worth a look. Defensive stocks have also traditionally performed well and sometimes REITs as the exposure to increases in rental income helps.
What about that regime shift?
The title of this article was about a potential regime shift in the UK markets. But to answer that question, I had to define what I mean by regimes and why changes in them are important. Now that is out of the way, I can say that rising inflation, or expectations about inflation increasing has been driving the markets for at least a year. Now inflation looks to be moderating, and growth is firmly in focus.
Falling inflation and lower-than-expected growth suggest a deflation regime, which is a shift away from stagflation or reflation, which are the two quadrants where I reckon investors thought they were previously. So, I do believe that UK markets are in the middle of a regime shift. But which ones? The FTSE 100 is dominated by global companies, so global inflation and growth are what should determine the regime in that index. That’s the one that is more likely in my opinion to be shifting towards a deflation regime in terms of investment options and allocations. The FTSE 250 is more domestically focused so UK growth and inflation are more important there. Deflation there is a possibility, but stagflation is also a worry, but luckily, the types of stocks I would pick in both scenarios are similar.
James J. McCombie does not own any of the shares mentioned. No comment in this article should be construed as a recommendation of, or opinion regarding the future performance of, any stock or security or collection of them mentioned herein. Opinions expressed are the author’s and do not represent the views of The Storied Investor. The Storied Investor has no beneficial ownership position in any of the stocks or securities mentioned.
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