AOA ETF: Peak Inflation Play; Still Indexes Broader Market

Published on the Value Lab 10/21/22

The iShares Core Aggressive Allocation ETF (NYSEARCA:AOA) is not especially aggressive. It holds other ETFs, mainly the iShares Core S&P 500 (IVV), and its performance has been very much in line with the broader S&P. This is what we don’t like about the ETF, it adds not value because the IVV, which it mostly mirrors, is just cheaper to hold. We complained about this in the last article and all of it applies. However, the environment is changing a little. While we’re still getting inflation and rate hikes, there’s been some time for lower prices in critical bottlenecks to adjust. This might start easing inflation. The main risk to peak inflation speculation is the wage-price spiral.

Reminder of AOA Holdings

The holdings have not changed to any meaningful degree from our previous coverage. It holds about 80% in equities, and half of almost all of it, except for about 10% of the overall AOA is in large-cap equities. The rest is in bonds, specifically the iShares Core Total USD Bond Market ETF (NASDAQ:IUSB) which we’ve also covered. These bonds are quite long-duration, and therefore are also ‘aggressive’ relative to other bond ETFs, although a lot of the IUSB exposure are Treasuries, so credit risk isn’t really there. Until this last year, duration wouldn’t typically be considered a dimension of aggressiveness.

Remarks on Economy and AOA

The current environment has been affected by markets’ concerns about stagflation risk. Higher rates and high inflation hurt the balance sheet and the consumer markets for those businesses. Equity and debt both suffer as pressure mounts on all instruments to be able to outcompete a higher reference rate after years of rock-bottom rates. The question that markets have been ceaselessly speculating on has been where will inflation peak. Repeated disappointment when inflation continues has been the reason for the stepwise decline of the US indices. Some commentators believe that this is at least to a meaningful extent a demand side problem. In the US that may be more the case, but in general it must be a supply side problem, as supply chain dislocations and a push to onshoring have monumental impacts on cost savings across the global economy, and the loss of leverage on comparative advantages between economies in the East and the West really matter for a goods-focused economy.

Some of the supply side pressures are easing however, likely a consequence of lowered demand due to rising rates and living costs dissuading quite the same velocity of consumption. Charter rates in shipping and in general logistic prices are seeing some reversal. Charter rates especially, which are a cost separate from fuel costs, are seeing pretty substantial reversal especially in dry bulk markets – less so in containerships. With logistics having been a key bottleneck, this takes the pressure off the original factor that caused our inflation.

The risk then is that despite the disappearance of the original factor, wage-price spiral could propagate it. According to the IMF, wage-price spiraling is a freak event and they claim it’s not kicking in. Indeed, many are attributing the Fed rate hikes now as being a way to mainly stem expectations of inflation that would kick off the wage-price flywheel, and therefore that the rate hikes could reverse if market tantrums are excessive enough. If there isn’t a wage price spiral, then the inflation we are seeing is not going to be a problem, because a lot of supply side pressures are easing, just look to semiconductor inventories which are signaling an oncoming glut after longstanding shortages.

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

However, we are slow to buy that we can forget about wage-price spiral. It’s food and shelter that are inflating the most right now, also there is service inflation which is very sticky downward because services are human capital and therefore wage-cost intensive. When governments and corporations try to tell employees whose real wages are falling that it would be bad for them to negotiate higher wages, because it would force corporations to price up and start a flywheel, people may just flip them off, strike, make lots of issues and take advantage of a tight labour market. Why shouldn’t they? Government has put us in this position in the first place, and it was quite easy to foresee where things were going in early 2020.