"Transitory" inflation, the failure of imprecise language, and unanchored expectations

 

There are two major inflation themes or questions currently being discussed. 

One, what the heck does transitory mean in terms of forward guidance for investors? The Fed started this discussion and has been unable to stop it. When will inflation come down, and if it mean-reverts, what is the new normal?

Two, do we have any idea of how inflation works in the economy? The Jeremy Rudd Fed paper has exploded in the macro discussion marketplace with the provocative view that no knows how inflation moves through the macro economy and no one know the link between inflation and inflationary expectations. See "Why do we think inflation expectations matter for inflation? (And should we?)". We can add to this issue the introspective work by the ECB that concludes it does not have any skill forecasting inflation. 

These discussions are more that inside ball between macroeconomists. The failure of imprecise language with respect to transitory inflation is creating uncertainty. If there is uncertainty, investors should be paid a premium to hold risky debt instruments. Forward guidance for central banks should be simple. if you cannot be precise in your language, don't say anything. 

If inflation numbers are not grounded in a well-define theory with variables that can tell us something about the future direction of prices, it is hard to understand why investors should again hold risky debt instruments in a rising inflation environment.  

Without beating a drum, if the underlying variables that drive inflation cannot be articulated and if the Fed cannot define transitory for the variable it is responsible for managing, investors should only focus on market opinion driven by dollar votes. Follow the price trend action. The fundamentalists may not like it, but the burden is on them to give a good reason why this should not be the rational choice.

Alternative Risk Premia (ARP) timing - Use macro factors for your advantage

Alternative style risk premia exist across all asset classes, equities, fixed income, currency, and commodities. The ARP returns are highly variable but generally positive. The correlations across these ARPs are generally close to zero with only a few showing significant values. It has been found that macro factors can be explain the variation in the times series of the risk premia. 

In a practical paper on the link between macro variables and ARPs, "Time-varying Factor Allocations", the authors show that tilting exposures based on signals from macro predictors can add significant value to any ARP portfolio. These macro predictors include business cycle indicators, inflation, and short-term rates. Carry, value, and momentum styles are all sensitive to macro predictors.

The tilting strategies using different macro variable generate significant excess returns relative to a naive basket portfolio.

The predictors that serve to tilt the ARP portfolios show significant value-added relative to a naive strategy.

 Alternative risk premia returns will change with the macro environment. Investors who want to create portfolio improvements can use macro now-casts to adjust their exposures to asset class styles. 

Inflation expectations and anchoring to actual inflation - Who knows?

 

Inflation is a global problem. More than have the economies of the world are seeing accelerating inflation. The US is one of the few that has seen some deceleration in the last three months, yet US inflation has been at a higher level than many other countries. Transitory currently does not seem to have strong meaning for economies.

Beyond the transitionary issue, the real focus for many investors is on the expectations of inflation and whether these expectations impact actual inflation. A recurring view is that the Fed should focus on controlling inflation expectations because these expectations are what influence and drive current price behavior. 

A provocative paper from a Fed staff economist, Jeremy Rudd, states that any link between expectations and actual inflation does not have strong support. See "Why do we think inflation expectations matter for inflation? (And should we?)" Rudd argues that what we assume about how inflation dynamics work is questionable and is not the simplest explanation. Any link between inflationary expectation and how people act when setting prices and negotiating wages should not be given as a normal. If we don't know or understand the process of how prices rise, then it will be difficult to control. The Fed cannot give forward guidance on policy and inflation and expect it to be useful if the process for how inflation moves is unclear. 

When we look a current inflation, we can easily draw a conclusion that many prices are set outside any expectations about central bank behavior. Port congestion, energy logistics, health costs, and wage negotiations for many employees are not influenced by expectations embedded in Treasury break-evens, TIPs, or forwards. We still don't know a lot about the inflation process.

Macro uncertainty and an energy shock generates a September correction

 

September was a bad month for risky assets, so we have seen better bond returns and a flight out of overvalued US equities. The reasons were varied: China Evergrande contagion, COVID cases, and Fed taper issues coupled with a negative energy shock. A close look at the US market shows that the largest declines started after the Fed FOMC meeting which solidified taper action by year-end. 

The good news is that COVID cases are falling, the worst Evergrande fears have not manifested, and the real effects of a Fed taper problem is still in the future. 

The energy shock, however, is front and center around the world and does not seem to have an immediate solution. Energy supply logistics are hard to adjust quickly. An economic recovery only exacerbated the demand for energy which pushed prices higher. The supply side, unfortunately, cannot be solved even with higher prices in the short-run. Inflation may be less transitory, but energy shocks effect the entire global economy. Any energy shock will have weaker real effects than in the past but that does not change the potential drag on real income and the economy when supply is just not available.

The impact of this price correction is still small. Equity prices are still above their 10-month moving average and September, the worst seasonal month by average monthly return from 1964-present and lowest percentage positive returns, has passed. Nevertheless, fiscal and monetary policy uncertainty not just in the US will make for a difficult environment for risky assets.

postive flows inot stocks and bonds as mesured by ETFs