The Inflation Genie – jumping back in the bottle?
Inflation, when out of hand, wrecks an economy! Just ask those living in emerging economies who are much more accustomed to living with soaring prices and limited prospects of meeting higher costs. On the other hand, the majority of society in Western Europe and North America, living beyond their means using borrowed money, have not experienced an inflationary cycle for at least four decades, if ever! The recent rise in inflation becoming a cost-of-living crises, confirms it caught everyone by surprise, unravelling everything consumers, governments and central banks thought they knew and had planned for.
Readers might ask what causes periods of high inflation? Looking back over time, inflation is typically triggered by geopolitical conflict or major supply disruptions. Western economies experienced periods of inflation in the aftermath of the First World War, in the aftermath of the Second World War and the Oil Crisis in 1973, a consequence of Arab-Israeli War. More recently the troubles in Ukraine have had an impact on inflation in its consequences on food and energy prices.
For macro investors and asset allocators, inflation is a key component in any top-down economic model. Alongside liquidity and economic growth, inflation is also a key factor in our top-down investment framework, and as such, crucial we understand what’s driving inflation and in which direction we think it is headed.
There are some factors that lead inflation, i.e. a rise in prices results in a rising Consumer Price Index (CPI), whilst others that lag, i.e. prices rise in a response to a rising CPI. Higher oil prices for example, lead to higher production costs, transports costs…higher everything! So rising oil prices is a leading indicator to inflation. Wages on the other hand, is a lagging indicator. However, you test wage growth, the correlation is highest with CPI data about six months prior.
Our modelling and testing effectively conclude that there are two variables with a significant correlation with future inflation, those being:
- Energy prices – a combination of natural gas and oil, and
- Money Supply – where M2 has the highest statistical significance, and broadly consists of cash, cash deposits and savings that can easily be converted into cash, within an economy.
The next step is to understand how many months you have to bring these factors forward in order to get the greatest statistical significance and best correlation. In recent history, natural gas has a high explanatory power, whilst longer term, oil as a standalone variable works better. Due to increasing importance and input into production processes, we use a moving average with a 50/50 split between Oil (as measured by WTI[DR1] ) and Natural Gas (as measured by Henry Hub) as our energy variable. Money Supply growth has a longer lag time before it shows up in inflation data – anything between 12 and 24 months, according to our model
One component of CPI which always stimulates debate amongst economists, is the Owner Equivalent Rent (OER), which makes up the majority of the services component in the CPI index. OER is a very sticky component and slow moving due to the way its calculated, however, has a very high correlation with a moving average of aggregate house prices over time – about 10 months forward. On its own, house prices do not have a sufficiently meaningful correlation with CPI to suggest any statistical significance. However, when added as a third variable to our inflation model, the overall model’s statistical significance improves materially.
As a result, our inflation model consists of these three components:
- Energy,
- Money Supply, and
- House Prices
Another important factor, but one which is very difficult to model, is inflation expectations. Inflation expectations is a key driver of sentiment…for consumers, employees, manufacturers…the whole economy really. The problem is the best predictor of inflation expectations seems to be inflation itself, which results in a type of ‘autocorrelation’ which is impossible to model. Inflation expectations feeds directly into wage expectations and consequently, wage growth.
Running various regressions, the only statistical significance we found between wage growth and CPI is when you lag wages by about six months, and even then its relatively weak. Compare this to oil prices, which if you bring oil forward by a month or two, consistently has a strong positive correlation with CPI data. So, all evidence suggests wage growth is a lagging indicator with no statistical forecasting ability.
Once we have our variables, the next step was to determine the right weight to allocate to each factor. As you can imagine, this is quite dynamic over time. For example, over a 40-year period, a multi-factor regression would suggest a 40% allocation to energy. Looking at the last 5 years only, money supply was by far the strongest predictor of inflation, and a regression would only suggest 10% allocation to energy. As such, we’ve built a dynamic allocation model, which changes the allocation – within limits – to each variable to ensure the best statistical predictability.
All in all, we know the model will not be 100% accurate – but it will tell us the direction and potential extent by which inflation might change over the next 12 months. We can compare this to inflation expectations data backed out of treasury markets and from surveys from the Federal Reserve. In combination, this is invaluable in helping us decide where the market is likely to go over the coming 3 to 6 months, and what it means to be contrarian!
So where is inflation going?
Energy prices are down about 30% from their highs earlier in the year. In the absence of a 50% rise, and with a recession expected in 2023, it’s difficult to see increases in year-over-year prices over the next six to nine months. Furthermore, following the extreme economic liquidity injection during COVID, we are now seeing base effects playing out as ‘QE4-ever’ comes to an end. In November, Money Supply (M2) growth fell to its lowest level since the mid-90’s.
The final variable – house prices – is set to decline in the face of rising mortgage rates. House prices in the US have started to roll over, and we’re unlikely to see this number grow significantly in the absence of a major decline in interest rates, another factor that is unlikely to occur until we see labour market weakness. Indeed, Shelter is the only component still keeping CPI above that ‘magic’ 2% level.
This leaves us with inflation set to materially collapse in the months ahead, which should bode well for long duration assets. Whilst the ultimate duration play is growth equities, its perhaps still a bit too early to pile back into this sector. Especially given the probability of a recession and tighter liquidity conditions. However, other asset classes may start to look attractive. For example, long duration treasuries look very attractive, especially in the face of positive real yields following the drawdown over the last 18 months.
Against a backdrop of rising inflation and economic uncertainty, many investors have shifted their investment strategy in response to the effects of inflation. If we are yet again moving into a new regime and perhaps even more challenging environment, investors should be minded to shift their investment strategy once again amidst the gloomy economic outlook.
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Past performance is not a guide to future performance. It is important that you understand that with investments, your capital is at risk. The value of investments, as well as the income derived from them, can go down as well as up and investors may get back less than the original amount invested. It is your responsibility to ensure that you make an informed decision about whether to invest with us, based on your particular objectives. If you are still unsure if investing is right for you, please seek independent advice.
The information and opinions expressed within this document are the views of (the company) and are based on information we believe to be reliable, but we do not represent that they are accurate or complete, and they should not be relied upon as such. Any information provided is given in good faith but is subject to change without notice.
No liability is accepted whatsoever by (the company) or its employees and associated companies for any direct or consequential loss arising from this document.
Disclaimer:
This document is provided for information purposes only and is intend for confidential and sole use by the recipient. It is not to be reproduced, copied or made available to others. The information set out in this document does not constitute investment advice or a personal recommendation. The views expressed in this document are not intended as an offer or a solicitation, to purchase or sell any security or other financial instrument, credit or lending product or to engage in any investment activity.
Past performance is not a guide to future performance. It is important that you understand that with investments, your capital is at risk. The value of investments, as well as the income derived from them, can go down as well as up and investors may get back less than the original amount invested. It is your responsibility to ensure that you make an informed decision about whether to invest with us, based on your particular objectives. If you are still unsure if investing is right for you, please seek independent advice.
The information and opinions expressed within this document are the views of (the company) and are based on information we believe to be reliable, but we do not represent that they are accurate or complete, and they should not be relied upon as such. Any information provided is given in good faith but is subject to change without notice.
No liability is accepted whatsoever by (the company) or its employees and associated companies for any direct or consequential loss arising from this document.