Stagflation, Stochasticity, Simplicity

The consensus is that stagflation is the consensus.

The awkward wording there is intentional. At times like these, when the macro environment is especially ambiguous leading to pervasive angst and uncertainty, it can be difficult to discern the narrative. It’s a discordant cacophony of disparate opinions, none of which can be described as “informed” in any strict sense of the word.

Given geostratgic realignments, fracturing frames of reference (e.g., de-globalization) and the demise of associated secular religions (e.g., the repudiation of “just-in-time”), macro outcomes could begin to demonstrate stochasticity, leaving all of us more or less bereft.

In such cases, there’s no “consensus.” It’s more like ranked choice voting for macro narratives. Through laborious effort we can declare a winning narrative, but whatever that narrative is, it’s not exactly “consensus.”

Even when we can divine a true consensus, it’s complicated by definitional ambiguity. Consider, for example, stagflation. That’s generally seen as the consensus macro narrative for 2023, and if that’s not quite accurate than let’s say it’d win on a ranked choice ballot. But how do we define stagflation?

The figure (below) is from the November vintage of BofA’s closely watched Global Fund Manager Survey. I included the accompanying explanatory color from the bank’s Michael Hartnett.

92% see stagflation over the next 12 months. Nobody expects a return to the vaunted Goldilocks regime.

We could assign numbers. Anyone can quickly produce a rough estimate of trend growth and trend inflation. But there’s still some ambiguity.

For example, 1% growth and 3.5% inflation in the US surely counts as stagflation. It’s not severe stagflation, but a 1% expansion isn’t great, and neither is price growth that’s almost double the Fed’s target. But I think most of us would agree that 1% growth and 3.5% inflation would count as a soft landing in 2023, assuming it wasn’t accompanied by too big of an increase in unemployment.

Consider what the market reaction to such a conjuncture would probably be. I don’t think I’m being hyperbolic to suggest that if the Fed can somehow manage to keep the expansion alive, while bringing inflation down by two full percentage points without a marked jump in joblessness, financial assets would be elated, even if Fed funds does loiter around 5%.

Money managers, jaded by 2022 perhaps, aren’t inclined to such a view. Instead, they seem prone to a glass half-empty assessment. “Central banks will overtighten and push economies into moderate recession, but will stop hiking before they [do] enough to get inflation all the way down to target as the damage from rate hikes becomes clearer,” a BlackRock strategist quoted by Bloomberg for an article featuring the same BofA chart shown above, said.

There’s something inconsistent about the notion of a Fed that “overtightens” before they’ve “done enough.” Unless, of course, the link between demand (over which the Fed holds some sway) and inflation is severed due to the above-mentioned stochasticity. If the Fed “overtightens,” that means, almost by definition, that policy crippled demand enough to force a recession. In theory, that should be enough to bring inflation to target. If it’s not, there are only two possible explanations. One is that we needed a deeper recession. The other is that in a randomly-determined macro environment, inflation may not always be responsive to shifts in demand, no matter how large those shifts.

If you read the linked Bloomberg article, there’s not much in the way of consensus on how to trade. The BlackRock strategist is underweight DM stocks and bonds, but ready to buy corporate credit. Another strategist from one of Wall Street’s biggest banks is selling credit, along with US stocks and buying bonds. Someone else (Morgan’s Andrew Sheets) suggested stocks and bonds could both be fine (“Bears say soft landings are rare. But they happen.”) And so on.

The fund managers in BofA’s poll are still holding the most cash in decades (figure on the left, below).

Although up from last month’s record underweight, the net percent overweight stocks remained 2.4 standard deviations below average (figure on the right, above).

At the end of the day, everyone thinks everyone else expects stagflation. But at least on some iterations, stagflation could be consistent with a soft landing. Nobody knows whether macro outcomes will be predictable going forward, which probably doesn’t matter much because even when they were predictable (i.e., during The Great Moderation) we were universally terrible at predicting them.

It’s small wonder that no one is quite sure how to trade given the sheer amount of indeterminacy. As is my wont, I’ve fallen back recently on common sense. If you have a fairly sizable sum of idle cash, where that means at least six figures not dedicated to an IRA or parked in a money market settlement fund that you may need to deploy should an opportunity arise, you could avail yourself of a veritable cornucopia of FDIC-insured cash products sporting sizable yields, and that’s to say nothing of bills.

That’s not any sort of investment “advice,” it’s just stating the obvious. Inflation does “swindle” everyone, as Warren Buffett mused this year, but remember that everyone has their own personal inflation rate. In the simplest possible terms: It depends on what you buy — what your own consumption “mix” is.

That’s the crux of the “K-shaped” inflation tragedy. Inflation tends to be less onerous the further up the wealth ladder one goes, a wholly deleterious state of affairs from a societal perspective.

But from a purely selfish perspective, the yield on some risk-free, insured savings products is now at or near (and, in the variable rate products, will likely soon be above), my personal inflation rate. When you consider that alongside what’s on offer in short-term (i.e., very low duration risk) IG corporate credit and a much improved risk-reward asymmetry in bonds compared to the era of negative yields, it’s not obvious to me why this is so vexing for so many professional stewards of capital.