Choppy inflation may be the worst inflation

Investors buying into the narrative that central bankers have decisively tamed inflation had their faith shaken last month, when the January US Consumer Price Index came in hot on February 13, sending stock prices tumbling.

The latest report revealed that the core CPI experienced a year-over-year increase of 3.9%, 0.2% more than expected. The news led to a spike in yields on 10-year Treasury bonds, as investors reassessed the potential for higher rates for longer. The likelihood of a rate cut in March sits at just 6%, with the market now anticipating a cut in June, according to a JP Morgan report issued on February 14.

Meanwhile, the latest consumer expenses figure – the Fed’s preferred inflation metric – was 0.43% higher in January. While broadly in line with analyst forecasts, the jump was nevertheless the highest single-month rise in a year.

The prospect of re-emerging inflation has investors worried. Sticky inflation was the second ranked risk in Risk.net’s Top 10 Investment Risks for 2024. In its February outlook, Man Institute labelled a resurgence of inflation as one of the biggest risks to markets in 2024, stating that while many observers have been preoccupied with the debate over whether economies will experience a soft or hard landing, limited attention has been given to the risk that central banks have failed to subdue inflation, citing high housing and rent costs, freight pricing, and geopolitical related supply-side shocks. 

Arguably of still greater concern, though, would be volatile inflation. 

Even before the hot inflation number, quant asset manager Research Affiliates was battening down the hatches for bouts or spikes of inflation over the next three to 10 years. In environments where there’s high inflation volatility, the firm observes that most directional bets on assets underperform. Stock slump when inflation is high and volatile, while bonds get burned when inflation is rising. 

“It’s not necessarily so much the level of inflation, but rather the volatility of inflation. If inflation is just a steady 3% for years, assets will respond in a certain way. If we see an average of 3%, but you’re at 0, and then you’re at 6%, you get very different responses,” says Jim Masturzo, head of the multi-asset investment team at Research Affiliates.

A hedge fund portfolio manager agrees: “If inflation volatility is very low, you can plan for that. If inflation volatility is high, you can’t.”

According to the portfolio manager, inflation volatility is highest in “extreme” episodes – namely, high and rising inflation and low and falling – and lower in disinflation and reflation. 

Research Affiliates has started to prepare for choppy inflation after conducting research on past inflation cycles. The firm found that “rapid dissipation” of inflation has seldom occurred in the past. Meanwhile, serious bouts of inflation of 8% and above – such as the 2022 peak in the US – are rarely benign or short-lived. Instead, inflation tends to move to higher levels or “accelerating inflation”.

Out of 21 episodes of 8% or higher inflation examined by Research Affiliates, 18 progressed to even higher levels of 10% or beyond. Additionally, four of these episodes featured multiple peaks, dropping below 4% before ricocheting back above 8%.

Looking ahead, Masturzo posits a lengthy period of inflation volatility due to government debt and deficits, especially in developed markets where significant debt-to-GDP ratios prevail. 

Consequently, the firm is taking risk out of the portfolio – favouring liquid alternative strategies and exploiting risk premia or spreads between assets, rather than taking on beta in stock, bond or commodities markets.

“Inflation volatility is going to be higher going forward,” he says. Where can investors take shelter? Masturzo backs strategies such as long/short relative value or long value/short growth. 

“Anywhere where you can take a long position in value or quality and either underweight or outright short more-risky growth, we think are poised to outperform,” he says.

Editing by Alex Krohn