Beware those that claim inflation is dead. Its alive and well, understanding where it is heading is key to the market’s direction, writes Landon Whaley.
This week’s “Headline Risk” comes courtesy of the Old Institution and their predilection to highlight a market theme after the move is over, and not beforehand.
The fine folks at The Economist trot out several smart-sounding reasons why they believe inflation, as an economic indicator, is as dead as disco. “Most economies no longer struggle with runaway prices. They find inflation is too low…A decade of interest rates at or near rock-bottom has not changed that. Nor have unemployment rates that are in many countries the lowest they have been for decades.”
The problem with the crux of The Economist’s argument is that it highlights the Old Institution’s obsession with the levels of data rather than the far more critical rate-of-change (ROC). Further, it’s clear that, like many constituents of the OI, The Economist doesn’t understand that the ROC of inflation has a profound impact on both the risk and return of asset classes.
Fundamental Gravity Says What?
There is only one thing that differentiates a Fall Fundamental Gravity from Winter, the trajectory of inflation. Yet, these two financial market environments couldn’t be more different.
From a portfolio management perspective, Winter (when inflation is slowing) is the time to batten down the hatches, minimize your gross exposure, raise your cash pile and build an igloo out of it. Minimize your long exposure to anything outside of the local currency or government debt. While you’re minimizing risk on the long side of your portfolio, Winter is the time to press as much short exposure as you can possibly stomach.
However, Fall (when inflation is accelerating) is the environment to dial back your exposure a bit compared with how much you’re willing to risk in a Spring or Summer FG, but you can still be reasonably aggressive towards equities and risk assets. Fall is also one of only two FG environments where it’s advisable to be actively shorting, but because it’s not uber-bearish like Winter, you want to be discerning about your short exposure.
The basis for these differing Fundamental Gravity descriptions can be found in the risk and return profiles of crucial markets.
The Market Says What?
Crude oil is perhaps the best single example of the difference that inflation’s trajectory can have on an asset class. Growth slows in both Fall and Winter, but because inflation accelerates in Fall, crude oil posts positive returns 64% of the time, with an average gain of 5.0%, and an average peak-to-trough drawdown of just -12.4%. However, when inflation is slowing during Winter, black gold is only positive 25% of the time, averages an 8.9% loss and experiences a crashworthy average drawdown of 20.4%.
High-beta stocks also have a Dr. Jekyll/Mr. Hyde performance profile depending on the path of inflation. In Fall, high beta names perform reasonably well, gaining ground 65% of the time, averaging a +0.8% return every three months with drawdowns of 12.5%. However, in Winter, these high-flying stocks are only positive 23% of the time, lose an average of 3.8%, and experience crash-test dummy drawdowns of 22.7%.
I challenge anyone to evaluate the risk and return characteristics of markets in an environment characterized by slowing inflation versus one where inflation is accelerating and then tell me “[inflation has] lost its meaning as an economic indicator.”
The Bottom Line
The “Headline Risk” bottom line is that magazine covers are the ultimate contrarian indicators. I can tell you unequivocally that inflation remains one of three critical factors to being consistently on the right side of market moves before they occur. Beyond that, not only is U.S. inflation not dead, it's waking the fudge up and about to catch the vast majority of investors wrong-footed. In Monday’s Playbook, we detail the how, why, when and where of inflation’s next move.
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