Nancy Davis Sees Stagflation Risk Rising

“Tuesday’s Consumer Price Index came in slightly stronger than expected and eclipsed the prior month’s elevated reading. Inflation is lasting much longer than expected amid supply chain issues, rising energy prices and increased consumer demand as the economy continues to reopen,” Davis wrote.

Davis reminded advisors and investors that the CPI is a measurement that lags inflation expectations, and said that she believes that a “signification disconnect” is occurring between the inflation rates that markets are currently experiencing and where inflation is expected to be in the future.

“The market expects inflation to decline, as the Federal Reserve embarks on interest rate hikes. We are surprised that investors seem to have complete confidence in the Federal Reserve’s ability to curtail inflation with rate hikes,” Davis says.

The current environment of inflation has a multitude of factors that are impacting and driving the percentages higher, including energy price increases from the Ukraine-Russia war, as well as ongoing supply chain issues impacting supply and adding ongoing inflationary pressure. It’s this pressure, one of the main contributors to inflation in Davis’ eyes, that is set to continue as interest rate increases have no bearing on supply chains.

“Given the risk of high inflation and with a hawkish Fed, the probability of stagflation is increasing, which is an environment that generally bodes poorly for both stocks and bonds,” Davis says. “So far in 2022, stocks and bonds have declined together.”

The Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL) from KFAFunds, a KraneShares company, is managed by Nancy Davis and is designed to have a twofold hedge against an increase in fixed income volatility and/or an increase in inflation. The fund also seeks to maximize yield curve increases, either brought about by long-term interest rates increasing or short-term interest rates falling; both are tied to big equity market declines.

IVOL is the first of its kind in active and passive options and offers access to the OTC fixed income options market, the mechanism it uses for long interest rate volatility. The fund invests in a mix of U.S. Treasury Inflation-Protected Securities (TIPS) of any maturity, which are U.S. government bonds whose principal amounts increase with inflation.

“Many investors have resorted to TIPS (Treasury Inflation-Protected Securities) to hedge their portfolios against inflation, but the value of TIPS is linked to the Consumer Price Index,” Davis explains. “The shape of the yield curve can capture inflation expectations in a way that TIPS cannot because the yield curve measures the rates at which banks lend money, which may be a more relevant indicator of inflation expectations than residential rental prices, which account for one-third of the CPI’s calculation.”

IVOL also invests in long options directly tied to the shape of the U.S. interest rate swap curve, which steepens when the spread between longer-term debt instrument swap rates and shorter-term debt instruments grows larger, flattens when the spread grows smaller, and inverts when the spread is negative.

IVOL is actively managed by Quadratic Capital Management, an alternative asset management firm with experience in the options and volatility markets. It expects to invest less than 20% of the fund in option premiums and seeks to purchase options with a time-to-expiration between six months and two years.

IVOL carries an expense ratio of 1.05% and has $1.7 billion in assets under management.

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