Friday, June 18, 2021

Inflation comes in different forms - some transitory and others longer-lasting

Some speak as if inflation is monolithic. There are actually different types or forms of inflation based on where we are in the business cycle or what could be a possible supply shock. These forms can be intertwined, yet it is important to think through the primary drivers. By looking at the forms of inflation, it may be easier to distinguish what is transitory, and what is permanent. 

For discussion purposes, we have outlined five forms of inflation. Each will have a different impact on equities, rates, currencies, credit, and commodities. 

There is classic demand-push that will be very relevant when there is limited slack in the economy. We are in a reflation, but demand-push may not fully engage with the US economy. The output gap is closing or has closed and unemployment is falling. However, the current reflation may be coming from other causes. That said, the natural rate of unemployment is not stable. What is full employment may be subject to change. A demand-push inflation may be good for equities because increased demand will allow for price increases. It is clearly negative for rates. 

Wage inflation, which we are likely experiencing, is a dangerous form for equities since companies have to pay-up for labor. Margins will be squeezed, and revenue share will move from capital to labor.

We separate cost-push from wage inflation and classify it as the operational costs of business which may include stock-outs, transportation costs, inventory, and regulatory issues. These all cut into profit margins but will impact sectors differently.

Commodity inflation can be viewed as mainly transitory, but if shortages are a function of underinvestment, these costs can be higher for an extended period. This would be foundation of a super-cycle.

Liquidity-driven inflation is associated with excess money balances, the classic monetary inflation often expressed in monetary theory. Excess money balances will be reduced through the purchase of goods or financial assets. This inflation, in the longer-run, will debase the dollar.

Granted this is a simple framework, yet discussion of the form inflation will help serve as focus attention on portfolio decisions.   

Thursday, June 17, 2021

Mapping styles in a macro world through partial correlation maps

Global macro trading is not easy, but it can be supported through simple tools that provide some conditional probabilities of success for asset classes and risk premia through measuring partial correlations on a grid between two factors. An investor's forecast skill may not be strong, but tilts can be created to exploit likelihoods for gains. See the older paper, "Mapping Investable Return Sources to Macro Environments" from AQR.

Directional as well as relative value macro trades are based on identifying and measuring the macro regime. Where are we in the business cycle? What is the inflation environment? Returns for asset classes as well as style premia are time varying and conditional on the macro regime. For example, commodities are positively correlated with growth and inflation. At the same time, bonds are negatively correlated to growth and inflation. Asset class tilts are possible to exploit the current regime.  Unfortunately, the partial correlations for style premia are more difficult to map because partial correlations are lower with respect to growth and inflation. Nevertheless, momentum and trend are both correlated with growth and inflation.

The 2x2 mapping for global macro can be extended to other macro variables like real yields, volatility, and illiquidity. In these cases, the investor is still burdened with identifying the macro environment. Conditional on the macro assessment, the investor can improve his odds of success through matching macro factor partial correlations with style premia and asset classes.    

Inflation and sector returns - Investors can exploit the differences

The impact of inflation on equity markets is not uniform. Theory suggests that equities should be neutral to inflation but reality is different. Without going through all of the reasons, sectors will have significant differences in inflation sensitivities. There are also different responses between inflation sensitivity levels and inflation surprises. These differences allow for construction of inflation sensitive and insensitive portfolios based on the inflation forecasts of investors or their desire to hedge inflation risk.

One of the broad factors for equity sensitivity is the level and acceleration of inflation, and currently we are in the worst market conditions, inflation greater than 3% and rising. The equity response to inflation is non-linear. In the current environment, the chance of the rolling 12 month return being positive is slightly less than a flip of a coin. Nevertheless, sector performance allows for portfolio tilts that will create some inflation protection.    


Wednesday, June 16, 2021

Fed comments - Don't focus on dot-plots, we have this under control

I needed some time to digest Fed Chairman Powell's comments, and it all comes to the same conclusion. The Fed is behind the curve with respect to monetary policy. 

1. The dot-plots have moved forward into 2023 with two increases. However, Chairman Powell told us not to look too closely at these numbers and "take them with a grain of salt". The producer of the numbers tells us that they are likely wrong. Ouch. Is this supposed to be forward guidance?

2. The Fed raised reverse repo rate and the rate paid on reserves held at the Fed. These are technical issues, but it tells us that there is just too much money floating around in the system. Without technical support, rates would fall lower. 

3. Inflation forecast for 2021 have moved significantly higher relative to March. So much for transitory inflation in 2021. Inflation in 2022 and 2023 are supposed to be tame; however, market expectations are not being well-behaved especially with consumers.

4. The Fed is now talking about tapering not "talking about talking about tapering".

Lookout for Eurodollar curve trading. We will get a wilder market on "go - no-go" trades.