ETF AOA: maximum inflation game; Always indexes a wider market


Posted on the Value Lab 10/21/22

The iShares Core Aggressive Allocation ETF (NYSEARC:AAO) is not particularly aggressive. It holds other ETFs, primarily the iShares Core S&P 500 (IVV), and his performance was very in line with the broader S&P. That’s what we don’t like about the ETF, it doesn’t add value because the IVV, which it primarily mirrors, is just cheaper to hold. We complained about it in the last article and everything applies. However, the environment changes a bit. As we continue to have inflation and rate hikes, there has been some time for lower prices at critical bottlenecks to adjust. This could start to dampen inflation. The main risk of speculation on maximum inflation is the price-wage spiral.

AOA Holdings Recall

Assets have not changed significantly from our previous coverage. It owns about 80% stock, and half of nearly all, except about 10% of the overall AOA, is made up of large-cap stocks. The rest is in bondsin particular the iShares Core Total USD Bond Market ETF (NASDAQ:IUSB) which we have also covered. These bonds have a fairly long duration and are therefore also “aggressive” compared to other bond ETFs, although a large part of IUSB’s exposure is in Treasury bills, so credit risk does not increase. is not really there. Until last year, duration was generally not considered a dimension of aggression.

Notes on Economics and AOA

The current environment has been affected by market concerns about the risk of stagflation. Higher rates and high inflation hurt the balance sheets and consumer markets of these companies. Equities and debt are both hurting as pressure mounts on all instruments to be able to outperform a higher benchmark rate after years of low rates. The question the markets have been speculating about is where inflation will peak. Repeated disappointments when inflation continues have been behind the gradual decline in US indices. Some commentators believe that this is, at least to a large extent, a demand-side problem. In the US this may be more the case, but in general it must be a supply side issue as supply chain dislocations and the push to offshoring have monumental impacts on cost savings across the global economy, and the loss of leverage on comparative advantages between Eastern and Western economies really matters for a goods-based economy.

Some of the supply-side pressures are easing though, likely due to lower demand from rising rates and the cost of living, deterring roughly the same speed of consumption. Rental rates in shipping and in general logistics prices are experiencing some reversal. Charter rates in particular, which are a separate cost from fuel costs, are seeing quite a significant reversal, especially in dry bulk markets – less so on container ships. Logistics having been a key bottleneck, this relieves pressure on the initial factor that caused our inflation.

The risk is then that despite the disappearance of the original factor, the price-wage spiral could propagate it. According to the IMF, the wage price spiral is an abnormal event and they claim that it does not occur. Indeed, many now attribute the Fed’s rate hikes as a way to primarily stem inflation expectations that would trigger the wage price wheel, and therefore that the rate hikes could reverse if market crises are sufficiently excessive. If there is no price-wage spiral, then the inflation we see will not be a problemas many supply-side pressures ease, just look at semiconductor stocks that signal an impending glut after long-running shortages.

This is encouraging, and while there may be more efficient ETFs, the AOA offers all-asset exposure to a dissipation of this fundamental risk of stagflation that could result in a wage-price spiral. IUSB’s long-duration bond ETF, but also US small- and mid-cap equity ETFs in addition to S&P’s core holdings are a relatively aggressive bet on a reversal of fortunes in the US economy, in particularly where mid and small cap companies are primarily more risky industrial players with the combination of higher rates to interrupt CAPEX cycles and high inflation to squeeze industrial margins.

However, we are slow to believe that we can forget the wage-price spiral. It is food and housing that are inflating the most at the moment, there is also inflation in services which is very sticky on the downside because services are human capital and therefore highly labor cost intensive. When governments and corporations try to tell employees whose real wages are falling that it would be wrong for them to negotiate higher wages because it would force corporations to raise prices and start a flywheel, people can simply turn them off, strike, make a lot of trouble and take advantage of a tight labor market. Why shouldn’t they? The government put us in this position in the first place, and it was pretty easy to predict where things were going at the start of 2020.

Carol N. Valencia