Monday, July 25, 2022

The inflation regime matters when anticipating returns across the business cycle

 


Bonds have rallied from lows and stocks have improved but both still show significant declines for 2002. The classic 60/40 seems to be showing some improvement, but it is important to remember we are still in a new inflation regime. When inflation is rising and and higher than average for the last 2 decades, the correlation between stocks and bonds should move from negative to positive. This new regime and stock/bond relationship may persist for years. (From "How a higher secular inflation backdrop may make this business cycle feel different" Fidelity Investments.)



The high inflation environment changes the expected sensitivity of bonds across the business cycle. Instead of seeing nominal yields decline during the late to recession period, we may see them rise with inflation expectations. The moves in nominal yields will be more exaggerated. If we see inflationary expectation volatility increase, there will be an increase in nominal yield volatility. We have already seen this increase through the bond MOVE volatility index.  


The asset class returns will also change across the business cycle when the inflation regime changes. The moves and opportunities in commodities become more exaggerated. Interestingly, we have seen a large commodity gain last year during the late phase of the business cycle and now we are seeing a commodity decline based on recession expectations.


The big question is whether a high inflation regime is likely to persist. Inflation may fall from recent highs, but investors are unlikely to forecast a return to a 2% target without short-term nominal yields rising to at least the expected short-term inflation rates. Long-term rates are not really controlled by the Fed, so the focus is on the ability of the Fed to eliminate negative short-term real rates. Given forecasts are already calling for rate cuts in 2023 based on an expected recession, we do not place much stock in a return to a low inflation regime. 







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