Hold the Inflation Victory Lap

Inflation still appears to be the biggest source of potential volatility in the market, and we think that’s because it will remain the dominant economic story for the foreseeable future.

Last Tuesday’s release of U.S. inflation data was a dash of freezing cold water for market participants.

Before the numbers came in, Asian and European equity markets were up. S&P 500 Index futures were pointing to another strong session, following the first run of five positive days since Russia invaded Ukraine. But when headline inflation printed two tenths of a percentage point higher than the consensus forecast, the Index slumped to its worst single-day loss since June 2020.

Inflation Inflection

The underlying data suggested that price pressures are becoming broader, stickier and more driven by demand and labor-market tightness. That shouldn’t surprise regular readers of our Perspectives: For a year, now, we have been arguing that the current spike is only the start of a new era of structurally higher inflation.

In February, we explained why we think higher inflation will be sustained by the four trends of deglobalization, China’s reorientation, greater fiscal liberality and decarbonization. We argued that because this “Inflation Inflection” is such a change from the conditions of the past 20 years, it’s important to consider deeply how it might affect each part of a portfolio, and how they correlate with one another.

Mitigating the impact of inflation might mean cutting interest rate sensitivity by favoring shorter-dated fixed income but also trimming speculative growth exposure in equity portfolios. At the same time, investors can try to take advantage of inflation with more of a tilt to real assets, investments that were out of favor for so long before 2022.

We think it’s particularly important to rethink portfolio diversification. We believe government bonds are less likely to cushion equity market sell-offs, putting an onus on investors to seek alternative diversifiers—particularly those positively exposed to inflationary dynamics.

We will be expanding this playbook soon to take account of the broader economic, social and geopolitical developments that are shaping this new inflationary era—so stay tuned for that.

Fear

Nevertheless, while many market participants understand and fear the longer-term scenario sketched above, they often seem reluctant to accept it. The potential implications about how aggressive central banks will need to be are too scary. As a result, the market appears to seize on any sign of easing inflation to be bullish, while remaining hyper-sensitive to setbacks.

Last week illustrated the dynamic well. July’s data, which suggested that U.S. inflation had peaked and was declining rapidly, had triggered an early victory lap. That was given further momentum last Monday, when the New York Fed’s survey of three-year inflation expectations fell below 3%. Tuesday’s slightly tighter than expected CPI data cut that victory lap brutally short. On Wednesday, a cooler U.S. factory-gate inflation report arrested the sell-off, and on Friday, the University of Michigan’s survey of inflation expectations also came in slightly lower than expected.

Noisy

What might all this mean for the next six to 12 months?

As long as inflation expectations are driving the market and the data remain this noisy, inflation is likely to remain the biggest source of potential volatility. Therefore, ahead of next month’s Asset Allocation Committee Outlook, we would say the guiding principle for the coming months is to anticipate elevated two-way volatility around the same inflation-related themes that we think investors will settle into over the next few years.

For example, the S&P 500 Index may have dropped more than 4% last Tuesday, but the FANG+ Index of technology stocks dropped by more than 6.5%, underlining the vulnerability of interest rate-sensitive equities. With the U.S. nominal 10-year yield approaching 3.5%, the two-year yield even higher, and the 10-year real yield hitting 1%, there is income to be had in government bonds once more. But as last week reminded us, if inflation doesn’t play ball, bond market sell-offs can still be both severe and tightly correlated with equities, even at these valuations.

As such, we continue to caution against leaning too heavily into equity markets rallies or “buying the dips,” and we still favor higher quality and lower beta exposures. We remain cautious on fixed income duration while seeing some opportunity in higher-grade credit spreads. That means we still regard non-bond diversifiers as critical, and we look through the current volatility to maintain our positive view on commodities and other real assets.