Trend-following and inflation - It is all about the uncertainty

 

Trend-following has been generating strong returns during this surge in inflation. This is not just a recent phenomenon. The data since 1979 supports the relationship between trend-following and inflation.  If the CPI is above 2.5%, trend-following will generate strong returns. If inflation is high and there is upside surprise, the returns are even stronger. 2022, the year of upside inflation, is showing exceptional returns as report in the FT article, "Inflation is a friend of your trend" by Nick Baltas. 

What is causing these huge trend-following gains? It is easy to say that commodity markets are the driver, but we have seen strong price reversals since the highs in March. 

The real reason for stronger trends is uncertainty. Inflation adds significant uncertainty on the direction of prices. Are the price increases caused by a general increase in prices, inflation, or just an increase in demand?

Inflation creates uncertainty for managers and investors who have to make real and financial decisions. Uncertainty creates noise. Uncertainty creates an environment that slows decisions. We are anchored in our past and that macro past has been one of stable prices. We are afraid of being wrong and suffering from regret.

The uncertainty that comes from higher and more volatility inflation is not just manifested in commodity markets. We see it in fixed income. We see it in stock indices, and we see it in currency markets. The core markets associated with trend-following are all affected by inflation is way that impacts decision-making. Every decision is slowed, and the results are trends.

An alternative look at the growth problem - The Lewis-Mertens-Stock WEI index

 

We have all heard that the two quarters of negative real growth is a recession. I like that estimate as a base for discussion, but the issue of when a recession begins and ends is more nuanced. That is why a NBER dating committee provides more precision on the peaks and troughs in the business cycle. There is also the problem that GDP is estimated and announced on a quarterly basis and most investors would like a more frequent estimate. 

One solution for providing more timely information is the Lewis-Mertens-Stock Weekly Economic Index (WEI) which is a high frequency estimate of the current quarter year over year real growth. The WEI is available from the St Louis Fed FRED database. The index consists of ten data sets.

The WEI is a composite of 10 weekly economic indicators: Redbook same-store sales, Rasmussen Consumer Index, new claims for unemployment insurance, continued claims for unemployment insurance, adjusted income/employment tax withholdings (from Booth Financial Consulting), railroad traffic originated (from the Association of American Railroads), the American Staffing Association Staffing Index, steel production, wholesale sales of gasoline, diesel, and jet fuel, and weekly average US electricity load (with remaining data supplied by Haver Analytics). All series are represented as year-over-year percentage changes. These series are combined into a single index of weekly economic activity.

The current estimate is that the YoY real growth rate is 2.95%. This compares with the actual YoY change in real GDP which is 1.67%. The WEI is suggesting that growth is stronger based on the index components. I will note that it does not have an inventory or export components which are the two areas which forced real GDP lower. The index clearly shows a slowdown from last year, but the current reading is currently higher than most estimates for the post-GFC period to the pandemic. These numbers are more consistent with the labor reading we have been seeing over the last year. 

I take an ensemble approach to the growth question. For the WEI index, the trend is lower, but the index numbers are more suggestive of a soft landing further in the future, stronger inflation numbers given higher GDP, and a healthy labor market. This is a good narrative but not consistent with general market sentiment.

Output gap and the business cycle - A good simple measure

 

A good way to look at where we are in the economy is to compare the real GDP against the real potential GDP. The difference between actual and potential is the output gap. An economy that is showing GDP above potential will be overheating and likely see inflation. GDP that is below potential and turning negative will indicate a slowing economy and a decline in inflation. 

The post GFC period showed a lower potential GDP, but actual real GDP posted numbers slightly higher than potential. Real GDP was generally lower than in the past and inflation was muted. 

The pandemic gave the US economy the biggest jolt down and then up ever seen. These dislocation from potential GDP played havoc with pricing decisions. We are now seeing real GDP fall below potential on a year-over-year change.

The quarter-over-quarter numbers shows the huge distortion from the pandemic in a more extreme form. We are now seeing numbers below potential and negative. There has never been a period where there has been a strong shift to negative real GDP without there being a recession. The data speak. 

Sector rotation and the business cycle - Risks change with the business cycle regime

A great July for many equity sectors does not change the reality that relative sector returns will be driven by the business cycle. Knowing where you are in the business cycle will create an edge when building portfolios. Some sectors are clearly cyclical while others are stable. 

Fidelity Investments provides a good chart on the relative performance of the major equity sectors. Of course, the real problem is that we often don't know where we are in the business cycle until it is too late. Let's assume we are late in the cycle or early in a recession. The sectors to hold are energy, consumer stables, utilities, and real estate. Consumer discretion and technology should be avoided. As we switch from late to early contraction, the allocation switch should be to reduce real estate and avoid financials, industrials, and technology. 

The current rally from a switch on policy beliefs has created havoc with these exposure choices, yet the economic evidence is on the side of following the business cycle trends.