Rising inflation, an uncertain growth picture and falling tail risks means this is an environment that rewards alpha over beta
We are living in interesting times, especially in markets. After years of falling macro volatility and benign inflation conditions, the market is now pricing the risk of a regime shift in inflation. This comes at the same time as China is undergoing its own regime shift to Xi-ism. Higher volatility should be expected, and it is being delivered
Front end yields and inflation swaps rose again last week; 2y UK inflation swaps rose by 27bps, CZK 2y swaps by 25bps and in Chile, where the central bank hiked rates by 125bps, 2y swaps rose by another 45bps. Developed market curves twist flattened; Dec 22 vs Dec 26 Eurodollar futures flattened by 28bps (2.6 weekly stdev), a similar magnitude of the move post the June Fed meeting, and US 5s/30s flattened by 20bps. The rally in commodities broadened, copper rose by 9.8% (1.7 weekly stdev) and in currencies the JPY significantly underperformed, due to the dual headwinds of higher energy costs and higher DM yields. Finally, equities rallied on a broad basis due in part to falling tail risks from Chinese property and a lower terminal rate providing a tailwind to technical breaks to the upside.
In aggregate, the market continues to price higher inflation risk premium in the front end of curves. This inflation risk premium drives demand for inflation hedges, especially in commodities and inflation swaps, and the risk of sooner, steeper hiking cycles results in flattening.
Growth, however, remains highly uncertain which is why the market continues to oscillate between stagflationary or reflationary price action. Last week, rates markets priced down the terminal rate, while real yields moved more negative. This is stagflation-lite price action, which is supportive for long-duration assets and equities, more specifically tech equities rallied.
So how much of this price action is justified, and does it change our view?
1. Inflation: Our core view is that we are in a higher inflation environment with a meaningful risk of a regime shift in long term inflation expectations. Central to this thesis in the US is the effect of the twin drivers of higher wages and higher rents on long term inflation expectations. Last week’s US CPI data has added confidence to our view. The details showed tenants rent jumping 0.45% and owners’ equivalent rent (OER) increasing 0.43%, the highest levels since 2006. Alongside rising wage inflation, the drivers of inflation are broadening beyond goods inflation, which characterized 1Q. On a global basis, add rising energy prices, food inflation, continuing supply chain bottlenecks, and you have a potent inflationary mix.
2. Growth: The data picture last week was mixed. US retail sales on Friday significantly exceeded expectations, rising by 0.7% vs a decline of 0.2 expected. Curves re-steepend following the data print as a strong US consumer is a necessary condition for a bullish inflation / reflation environment to actualize. In contrast, the University of Michigan consumer sentiment fell while year ahead inflation expectations rose to a new high of 4.8%.
In China, the PBOC struck a confident tone, stating that “we can contain the Evergrande risk” and it was reported that policy makers have loosened restrictions on home loans. This resulted in a strong rally in China property bonds on Friday.
However, headline macro developments were hawkish / credit contractionary. Credit data showed TSF and bank loan growth both fell in August; the PBOC did not cut the RRR as some had expected and signaled, they will use targeted liquidity tools to address credit tightening. Over the weekend, the Communist Party’s top theoretical journal issued an excerpt of Chinese President Xi Jinping’s 17 August “common prosperity” agenda, in which he clearly confirmed a shift to a tax and transfer environment in China, and that the era of laissez-faire wealth creation is finished. On Sunday night, China GDP data confirmed the sharp slowdown in Q3, showing real GDP grew 4.9%oya, following growth of 7.9%oya in 2Q.
Taken together, we observe the following dynamics at play.
First, inflation continues to firm and there are asymmetric upside risks to spot inflation over the winter due to energy costs. Second, central banks are responding to inflation as are market participants. The transitory thesis has weakened significantly, both in the mind of the market and central bankers. Third, the growth outlook is very uncertain over the medium term, but in the near term there are upside risks due to fading Delta effect, notably from NE Asia and the US. Finally, tail risks have eased, China credit is contracting, but the risks of a China property blowup have fallen.
We find this to be an environment that rewards alpha over beta. From a portfolio perspective it argues for a balanced portfolio, positively exposed to higher inflation, with a flattening bias in rates. From a trading perspective it argues for fading when the market prices extremes in the stagflation - reflation distribution, given the underlying macro uncertainty.
We have positioned our portfolio to reflect this view. We remain paid US inflation swaps, with flatteners in early cycle EM, and are exposed to energy moves via KZT, Russian, Saudi equities and Oil sector equity call options, and have long USD hedges. This is balanced with EM equity and credit exposure, which had underperformed significantly in the stagflation selloff late Sept and early Oct. Tactically, we have also added short-term call options on global equities. There is strong near-term technical support for equities and clear asymmetry, especially if rate volatility falls.