INFLATION CHECKLIST: BACK TO THE FUTURE
I started in the investment business in May 1978, when I transferred to the investment department from the “data processing” department at the insurance company where I worked. Inflation had been rising for some time. I’d already seen the OPEC oil embargo of 1973, though I was a student at the time. So when inflation started raising its ugly head again, I wasn’t surprised. Neither was anyone else. But the magnitude of what happened next shocked even the veterans around me. In 1979, when Fed Chairman Paul Volker announced that he was going to let interest rates float and target money supply, both the stock and bond markets experienced high volatility and high correlations. While I was an equity trader at the time, the fixed income section (which was huge since this was an insurance company) was shell-shocked. There were veterans there from the 1940s who had never seen anything like that. The memory has stuck with me.
Because of this experience early in my career, I developed an inflation regime checklist in 2008, much like the bubble checklist I’ve mentioned in previous blog entries. At the time, inflation had been low and stable for many years, but even so, I thought some sort of early warning system was a good idea. When inflation rises, asset allocation becomes a harder problem. Bonds, in particular, become a different asset. They tend to have higher correlation to equities and higher volatility, and lose a good bit of their diversification benefits as a result. US treasuries tend to keep their tail-risk hedging properties due to liquidity needs, but those will also be somewhat muted.
The inflation checklist involves both forward-looking and backward-looking indicators. Future inflation expectations are important because they influence things like wages and consumption. Trailing inflation is also important because investors tend to “anchor” in the behavioral finance definition of the term, to what they hear in the media.
Inflation expectations have been in reflation mode since October of 2020, and trailing headline inflation is now above 5% in the US and elsewhere. We have entered a “high” inflation regime. If trailing inflation begins to exceed 8%, we will be in a “very high” regime, like 1979. We’re not there yet, but we have started down that path. Whether we take a trip back to 1979 or not is unknown, but it is best to be prepared.
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