Why Stagflation Could be in the Cards and How to Position For It

This year has been a difficult one for markets already, with the Nasdaq entering a bear market as of close Monday— down 20.1% from November 2021 highs— and the Dow Jones officially in correction alongside the S&P 500, which had its worst day’s performance since October 2020, reported CNBC.

The market corrections come at a time when inflationary pressures are continuing, driving prices up while supply disruptions continue, growth is slowing, and the invasion of Ukraine adds uncertainty and further volatility to markets. Nancy Davis, founder of Quadratic Capital Management and portfolio manager of the Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL), believes that this could be setting the stage for stagflation when prices continue to rise while growth remains slow.

“A stagflation environment may hurt equities and bonds together, like what we have seen in 2022. In 2022, [the]S&P 500 is down -11.8% and Investment Grade bonds (using the LQD ETF as a proxy) [are]down 7.5% YTD,” writes Davis in a communication to ETF Trends.

With a hawkish Federal Reserve, rising inflation, geopolitical risk, and other factors, markets are facing a contingency of pressures on various fronts. It’s made for advisor and investor uncertainty on aligning portfolios for current environments and forward-looking.

“The IVOL ETF is well positioned to potentially benefit in this environment, as IVOL includes TIPS, which are inflation-linked US Treasuries plus interest rate options. IVOL is long interest rate volatility, which tends to benefit during periods of uncertainty and market stress,” Davis writes.

Davis explains that looking back historically since IVOL’s launch in May 2019, when the S&P 500 fell the most in the first quarter of 2020 (20%) at the onset of the pandemic and stocks and investment grade and high yield bonds were all down, the net asset value of the fund was up 3.69%. Having a fund such as IVOL included in a portfolio during market uncertainty and volatility can help add diversification because of its low correlation to stocks and bonds.

“During times of market panic, both stocks and credit bonds tend to decline together. Options tied to the shape of the yield curve like the ones held by IVOL can help a portfolio reduce correlations — lower correlations mean that a portfolio’s investments don’t all move in the same direction at the same time,” Davis writes.

IVOL Can Help Hedge Against Inflation and Volatility

The Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL) from KFAFunds, a KraneShares company, 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.

It 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 approximately $2 billion in assets under management.

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