An ‘Important Regime Shift’ (And A Word On Hindsight)

Remember when the pandemic was deflationary?

That seems absurdly quaint in 2022. But we’d do well to drop the haughty, faux derision we habitually employ while playing Monday morning macro quarterback. We chastise ourselves for being myopic in 2020, but hindsight is… well, 20/20.

Every day someone shows up on business television to deliver a play-by-play account of 2021. It’s usually couched in terms that suggest it was all painfully obvious. Our hyper-globalized world depends heavily on specialization, just-in-time and cross-border trade. We never bothered to establish a set of emergency mechanisms and failsafes to backstop the system in a crisis. We knew the next pandemic was just a matter of time. Intense nationalism was the political flavor of the day, which meant re-shoring and de-globalization were already en vogue. Trillions in pandemic stimulus had no outlet because everyone was stuck indoors. But eventually the world would reopen and if it didn’t, something had gone so wrong that fretting over macro variables would be irrelevant anyway. And we’re pretty adept at developing vaccines. COVID was destined to be inflationary sooner or later. It’s so simple! Or at least it is when you already know how it turned out.

When we retell that story, we tend to forget that almost all crises are equally easy to explain after the fact. It’s interesting to juxtapose the language we employ to describe economic and market events with how we talk about sports contests. We don’t call post-game shows “explanations,” we call them recaps. People purporting to “explain” why the pandemic was inflationary aren’t really explaining anything. They’re just summarizing 18 months of economic history. The same is true of the financial crisis, by the way. Once you strip away the CDO arcana and esoteric MBS language, the whole debacle was entirely amenable to summary treatment. So amenable, in fact, that Margot Robbie famously explained the whole thing while sitting in a bubble bath in the Hollywood adaptation of Michael Lewis’s bestseller.

In the beginning, COVID was a deflationary supernova for one simple reason: Demand was de facto illegal. You couldn’t shop, dine out, fly or even go to your neighbor’s house for dinner. Hence the initial collapse in market-based inflation expectations. Breakevens thus became a real-time referendum on the Fed’s success in averting a depression. As such, breakevens and risk assets tracked each other pretty much in lockstep (figure below).

In addition to signaling reflation success, rising breakevens mechanically pushed real yields lower, paving the way for higher equity valuations.

More recently, the positive correlation between stocks and breakevens has dissipated, which Goldman called “an important regime shift.”

“While for most of the last cycle and the post-COVID recovery equities have been positively correlated with inflation expectations, the correlation has turned less positive recently,” the bank’s Cecilia Mariotti wrote, in a new note.

When secular stagnation is a concern, deflationary pressures predominate and the goal of central banks is rescuing their respective economies from Japan-style disinflation, the interplay between inflation and growth expectations is virtuous. Now, though, the opposite is true.

“With inflation being higher and stickier than previously expected, the risks of negative feedback loops to growth have increased,” Mariotti went on to say, noting that year-ahead consensus data “show a large decoupling of growth and inflation expectations.”

The figure on the right (above) shows that decoupling. Note the plummeting light blue line against its surging dark blue counterpart.

The read-through is simple. “This points to growing risks of stagflation, in particular with central banks tightening financial conditions to get inflation under control, potentially at the expense of growth — and risky assets,” Mariotti said.

It’s tempting to leave it there — to let Mariotti’s quote punctuate yet another article dedicated to perpetuating the notion that stagflation is now inevitable, thanks to our collective shortsightedness in 2020. Instead, I’ll suggest that maybe — just maybe — we’ll look back two years from now and chuckle at how wrong we were. And how obvious it should’ve been.