“If one stretches rubber too long, it eventually snaps,” JPMorgan’s Marko Kolanovic wrote Wednesday, in a new note that began with a recap of the last decade, a period over which “inflation hedgers” threw in the towel as price pressures failed to materialize in the wake of the Fed’s unprecedented experiment in accommodative monetary policy.
In 2010, a veritable who’s who of market participants and other “brand names” famously signed an open letter to Ben Bernanke warning on the inflationary consequences of the Fed’s bond-buying program. “We do not believe such a plan is necessary or advisable under current circumstances,” signees, including Jim Chanos, Jim Grant and Cliff Asness wrote. “The planned asset purchases risk currency debasement and inflation,” they told Bernanke.
While some of the warnings contained in that letter proved prescient (e.g., “…[QE] will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy”), the esteemed authors were wrong on inflation. Or at least on inflation as measured.
Part of the problem was that they failed to anticipate forthcoming crises. They can hardly be blamed. After all, crises are hard to predict.
“The post-GFC recovery was weak, and new crises kept on emerging,” Kolanovic went on to write Wednesday, flagging the European sovereign debt crisis, tremors in China (e.g., the August 2015 yuan devaluation), the trade war, the global manufacturing recession and, of course, the pandemic.
“As no inflation materialized over the past decade, inflation hedgers threw in the towel, and inflation-sensitive exposures were shorted as investors piled on deflationary themes,” he said, reiterating the entrenched nature of the preference for secular growth, low volatility, duration sensitives and other bond proxies. “Driven by deflationary trends, bonds nearly doubled and the S&P 500 quadrupled since 2010, while Commodity indices significantly declined.”
Now, the tide has turned. Or at least that’s the way it seems. Treasurys are coming off their worst quarter in decades and commodities of all sorts are on fire (figure below). Inflation expectations are at multi-year highs, there are concerns that surging food prices could destabilize poor nations already struggling to overcome the pandemic and input price pressures are pervasive and acute. At the least, prices are headed higher in the short- to medium-term. The question is this: How does one define “transitory”?
All of this is colliding with surging demand as the developed world emerges from the pandemic. Meanwhile, the world’s largest economy is running the most expansionary policy mix in recent memory, with rates at zero, Fed bond-buying running full tilt and fiscal policy poised to deliver trillions in demand-side stimulus just the services sector reopens in earnest.
For Kolanovic, most market participants simply don’t appreciate the gravity of this, in part because, as I’ve been keen to joke, most investors and traders have never operated in such an environment. Only a relative handful of traders can honestly say they remember what it was like to actively trade when bonds weren’t in a bull market.
“On financial asset allocation, we expect the market to be late in recognizing the inflection, which we believe already happened in November last year,” Marko said Wednesday, adding that,
For over a decade, only deflationary (long duration) trades were working, and many of today’s investment managers have never experienced a rise in yields, commodities, value stocks, or inflation in any meaningful way. A significant shift of allocations towards growth, ESG and low volatility styles over the past decade (all of which have negative correlation to inflation) left most portfolios vulnerable to a potential inflation shock.
While the daily banter revolves mostly around the duration (no pun intended) of the coming spike in inflation, the more important (albeit closely related) question is whether “asset managers will make a significant change in allocations to express an increased probability of a more persistent inflation,” Kolanovic said, adding that in JPMorgan’s view, that shift will occur no matter how fleeting (or not) actual inflation turns out to be.
What does that mean going forward? Well, it means that as the data comes in, “investors [will] shorten duration, move from low volatility to value, and increase allocations to direct inflation hedges such as commodities,” according to Marko. This trend should continue at least into the second half of 2021, as the global reopening story unfolds.
Once portfolio managers wake up to the reality of higher realized inflation, he doubts they’ll be inclined to give policymakers the benefit of the doubt on the “transitory” messaging.
The Fed is committed (indeed, it’s now enshrined into the language describing the FOMC’s goals) to countenancing inflation overshoots. If you ask Kolanovic, “portfolio managers likely will not take chances and will reposition portfolios.” That process could be amplified by still impaired market liquidity, flow dynamics (both systematic and fundamental) and “the sheer size of financial assets that need to be rotated or hedges for inflation put on.”
In case it isn’t clear, the read-through for investors looking to reposition for this eventuality is that duration should be shortened, bond exposure trimmed, and commodities exposure upped. Within equities, value should be favored over min vol, and also over secular growth and quality, given all three are negatively correlated to inflation.
More broadly, JPMorgan’s year-end S&P target remains 4,400.