Could inflation surprises unsettle markets?

There is an old investment adage that says: “buy the rumor and sell the news”. Markets tend to try to anticipate forthcoming data such as inflation numbers, with investors building positions ahead of time based on their expectations. Once the outcome is confirmed, investors take profits (or cut losses) by exiting positions. 

 

Need to know: Episodes of high and low inflation should probably not drive asset allocation, as periods of high inflation often correspond to deteriorating growth conditions  Inflation surprises, as dated by our nowcasting indicators, show interesting patterns regarding asset returns. Notably, they are less influential in periods of deteriorating growth Current ‘low but rising’ inflation surprises in the US should be seen as yet another call for caution

 

Inflation as a deciding factor

If markets expect inflation to decline, bond prices rise ahead of the announcement. If the genuine number is in line with expectations, they then decline. Understanding this game of expectations is essential. As with any risk factor affecting markets, what matters is how much markets are surprised by the news itself, as most of the price action happens before the announcement, in anticipation of it. High or low inflation does not matter to markets: what matters is the direction of inflation itself. We have recently discussed how our inflation indicators have turned and, in this edition of Simply put, we highlight the difference between a positive inflation trend and a high-inflation environment.
 

With low inflation comes higher performance… right?

It may be considered naïve to think that a high-inflation environment is bad for investing while a low inflation one is friendlier. This idea is far from being rejected by the data (see figure 1). Here we provide an historical evolution of inflation in the US, split between periods of high or low inflation, as per the positivity of a full sample z-score. The annualised performance of equities and bonds during each period fully comply with the notion that returns are stronger in low-inflation periods. 

Episodes of high inflation are more complex to navigate than golidlocks periods, with notably negative returns on equities. As convincing as the chart may be, there is a different explanation to this phenomenon. Nine periods of high inflation have occurred since 1999, with unequal durations. Four can be matched with recessions: 2001 (dotcom bubble), 2003 (double-dip recession), 2008 (global financial crisis) and 2011 (the Eurozone recession). Aside from these, we are left with the 2021-2022 rates shock – which is obviously quite extraordinary – three very short periods of higher inflation (the 2009 recovery, 2017 and 2018) and the oil-driven inflationary period of 2005-2007.  This tells us two things: 

1. These periods show a lot of heterogeneity, making the significance of average returns debatable 
2. Five can be tied to deteriorating economic conditions (including the 2018 US-China trade war period).Leaving the 2021-2022 period aside, most exhibit negative equity returns – not driven by inflation but by deteriorating economic conditions 

So, should investors worry about the impact of inflation on markets?, Or were the past two years extraordinary?
 

Figure 1. US inflation (top) and historical Sharpe ratio (in excess of their full sample value) of equities and bonds during high and low inflation periods (bottom)

Source: Bloomberg, LOIM at August 2023. Bond returns are based on the Barclays Global Aggregate index and equities on the MSCI World index. For illustrative purposes only. Past performance is not a guarantee of future results.

 

The expectations game

Our inflation indicator offers an interesting and different perspective. It differentiates between periods of positive and negative inflation surprises instead of focusing on high and low realised inflation. By considering a vast spectrum of inflation sources, it allows a more nuanced take on the market impact of inflation – one which is more consistent with the idea of “buy the rumor and sell the news”. 

Figure 2 shows the average realised inflation surprise (the difference between realised and expected inflation) as a function of the previously named regimes isolated by our nowcasting indicator. Two conclusions can be drawn:

1. First, the key periods actually appear to be those with ‘high and rising’ inflation surprises and ‘low and declining’ inflation surprises. In other words, these are the times when initial inflation surprises occur 
2. Second, these episodes do not exactly match the high-inflation ones shown in figure 1. This is clear in figure 2. For instance, the 2000-2001 period is a ‘low and declining’ regime (versus a time of high inflation in figure 1). The year 2016 had one of the longest ‘high and rising’ inflation surprise regimes (compared with a short-lived period captured by figure 1). And the 2005-2007 episode is not a high-inflation period but one of ‘low and declining’ inflation surprises
    

FIG 2. US inflation vs ‘high and rising’ and ‘low and declining’ inflation surprise regimes

Source : Bloomberg, LOIM at August 2023. For illustrative purposes only.

 

Figure 3 shows that looking at inflation through this more nuanced lens shows a lot more discrimination between assets, notably in the case of bonds. Bonds show a Sharpe ratio that is below trend in the ‘high and rising’ inflation surprises case. Meanwhile, equities usually suffer during periods of positive inflation surprises – this time, not because of a deteriorating growth conditions but because of the rising rates that accompany them. This would indicate the following:

1. Inflation surprises are probably more impactful on asset prices than inflation itself, minimising overlaps with periods of deteriorating economic conditions
2. In our view, the current ‘low but rising’ inflation pressures in the US serves as a call for neutrality, which we have implemented. The same applies to duration risk, where we are underweight for volatility reasons
    

FIG 3. Inflation surprises as a function of LOIM’s nowcasting-based regimes (top) and equities and bonds’ Sharpe ratios in excess of their 1990-2021 averages as a function of such regimes (bottom)

Source: Bloomberg, LOIM at August 2023. For illustrative purposes only. Past performance is not a guarantee of future results.
 

Simply put, US inflation has been falling. But investors should remain mindful of the growing risk of inflation surprises.

 

 

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Nowcasting corner

This section gathers the most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary-policy surprises. These indicators keep track of the most recent macro evolutions that make markets tick.

Our nowcasting indicators currently point to:

• This week’s growth message remains the same: growth conditions are low but improving. This is due to 55% of the data that comprise our growth nowcaster are improving. In the US, this proportion has reached 60%
• Our inflation nowcaster continues to be ‘low but rising’. In its case, 70% of the data we collect are on the rise. For the US indicator 82% data are on the rise 
• Our monetary policy indicator reflects expectations that expect central banks will keep rates high

 

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

 

LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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