A fixture of various “new era,” economic-regime-shift commentary is the idea that macro volatility has returned and will be with us for the foreseeable future.
The decline in macro vol that characterized the so-called “Great Moderation” as well as the “Goldilocks” regime that defined the post-financial crisis years, was relegated to the dustbin history by the pandemic shock and, subsequently, the war in Ukraine. Going forward, cycles will be truncated and macro outcomes less predictable, a conjuncture not conducive to the kind of forward guidance market participants were accustomed to from central banks.
Or so the story goes. That’s the zeitgeist. If it’s accurate, it has serious ramifications for asset allocators and stewards of capital, who are now compelled to question some of the bedrock assumptions underpinning multi-asset portfolios, including and especially the idea of bonds as a reliable diversifier.
According to JPMorgan’s Nikolaos Panigirtzoglou, CPI volatility has now surpassed GFC levels, and should rise further over the next several months (figure on the left, below). The rapid rise in inflation vol is a hot topic among the bank’s clients, Panigirtzoglou said.
But bonds, at least, have looked through the spike. Obviously, yields are higher, but a simple scatterplot of 10-year nominals and 12-month CPI prints reveals an almost unfathomable disparity. Long-end US yields are nowhere near as high as their historical relationship with inflation suggests they should be. A more nuanced way of saying the same thing is just to suggest that term premia should be higher if bonds were truly concerned about a sustained rise in inflation volatility.
In an effort to determine if markets are justified in looking through the spike shown on the left (above), Panigirtzoglou looked at annualized three-month changes in CPI (as an alternative to simple YoY prints) and suggested that in fact, there’s some evidence to support the notion that inflation volatility is in the process of peaking.
In addition, he noted that “much” of the CPI volatility witnessed over the past 18 months was attributable to energy and reopening components. The latter have calmed down, the former not so much. “With a significant re-pricing in energy already having taken place, in principle this influence should begin to wane over time in the absence of further energy-related shocks,” Panigirtzoglou ventured.
He went on to calculate fair value for 10-year reals under various assumptions about the market’s predisposition for looking past inflation volatility. He did the same for stocks. “Equity markets have effectively looked through both the rise in real GDP volatility, given the significant policy support from fiscal and monetary authorities, as well as the rise in inflation vol after Q121,” he wrote.
JPMorgan’s fair value model for the S&P in a scenario where stocks continue to look through macro volatility is around 4,400 in Q2 (figure below).
You’ll note the black diamond in the figure. That’s the adverse scenario, which assumes markets begin to factor in inflation vol settling at levels more than twice as high as the four-decade average excluding the Lehman shock.
In that case (i.e., in the adverse scenario), the bank’s longer-term framework suggests fair value for the S&P is 3,350.
JPMorgan is generally constructive on equities, so Panigirtzoglou was careful to emphasize that the adverse scenario “would likely require a continuation of inflation surprises.” That isn’t the bank’s base case.
I appreciate seeing this- thanks. Yes if the markets thought you could have continuous inflation shocks- stocks and bonds would be significantly lower in price. I have some friends who are consultants/free lance and they are telling me that on the ground- opportunities are slowing down right now. This is something that has happened in the last 2-3 weeks so it is not reflected in the numbers. And it is only relevant for the NY Metro. Still, it is reasonable to assume that growth and inflation have seen inflection points. The real question is the speed of adjustment and durability of it. The real surprise would be inflation significantly slowing after this summer with a Fed/other central bank pause. If that happened I would expect less cyclical components of the stock market plus long duration bonds to take off. Lets see if that is correct. It is only a guess.
My personal opinion is that “wishful thinking” is becoming prevalent. Inventory surpluses, normalization of supply chains, victory by Ukraine, conquest of covid, ignoring climate change, an absence of political instability, ignoring housing insecurity, etc. will conqueror inflation. Right???? There are many things that have to “go right” for inflation to decline significantly. Inventory surpluses are temporary, supply chain may never normalize, the war might go on for a decade, pandemic diseases might become more frequent, droughts/hurricanes/etc. can ruin ports, crops, homes, etc. and homelessness will probably increase.
Focusing in on one of your points: NOAA predicts an “above average” Atlantic hurricane season this year, with an expected 3-6 major storms. I wonder what that will do to gasoline prices? The bellweather gas station down the street now has regular at $6.79/gal. By the way, the last six Atlantic hurricane seasons have been “above average.”
Clearly there are some variations here. I’m in MO and gas across the street from my house is 4.29 for reg (lowest gas tax in US, btw). Diesel is about a buck more. I wonder how much the loss of Sunoco’s big refinery in NJ sometime back has had on east coast gas prices?
The Fed’s continued bond purchases with maturing bond equity is suppressing yields.