An S&P That ‘Looks Through’ Inflation Vol Is 7% Higher: JPMorgan

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.