The Return of Volatility and Inflation Risk
Market expectations are shifting to focus on when, not if, inflation pressures will re-emerge and volatility will revert to more normal levels. How should investors respond?
The recent US inflation scare, which triggered a global spike in volatility and bond yields and a correction in share prices, demonstrated how acutely sensitive markets have become to changing inflation expectations and the prospect of higher interest rates. As indicated in this issue’s investment roundtable, our view is that markets appear to have overreacted to a single wage data point that has been historically quite volatile. Our core expectation is that inflation will remain contained this year and the fiscal stimulus from the historic US tax reforms will take longer to translate into persistent wage and price rises than many believe. Nonetheless, there has been a clear shift in market expectations to when, not if, inflation pressures will re-emerge and volatility revert to more “normal” levels. In this new, more febrile environment, it is important to assess the potential impact of higher inflation and volatility on company valuations and position portfolios accordingly. Asset allocators may also wish to consider whether previous diversification benefits still apply and how best to manage latent risks.
Volatility – Benign or Severe
Over the last few years, volatility has declined across major asset classes. Equity and bond volatility has fallen, as had currency volatility until recently. Historically, when the volatility of different asset classes declines simultaneously, it is primarily due to large amounts of liquidity provided by central banks as monetary stimulus. Figure 1 shows past levels of volatility in equity and bond markets compared to the current environment since the global financial crisis (GFC).
There are multiple sources of volatility that can affect asset prices and investor portfolios, but there are two significant ones for financial markets. Since volatility has been extraordinarily low for an unusually extended period and, until recently, was coming down, the return of volatility might just be a function of reverting to the mean as monetary stimulus is tapered in the US, the UK and Europe. If, as expected, monetary stimulus has been effective and growth has improved, then a reversion in volatility to more normal levels is likely to be benign and conducive to the compression of premia in risk markets.
However, if renewed volatility is the result of a spike in inflation risk, the consequences could be more severe. Prices in asset markets are driven by both realized inflation and anticipated inflation, which can be triggered by shocks in consumer prices, producer prices or employment costs. If volatility is driven by sharp rises in inflation or inflation expectations, equity and bond valuations will have to adjust quickly, which can be bumpy. We witnessed this effect on February 2 when markets reacted sharply after 200,000 jobs were added to the US economy compared to consensus forecasts of 180,000 and average hourly earnings grew by an unexpected 2.9%. Often central banks respond to a rise in inflation or inflation expectations by tightening policy or talking about higher rates, prompting further volatility. So far, that has yet to happen.
If, as expected, monetary stimulus has been effective and growth has improved, then a reversion in volatility to more normal levels is likely to be benign and conducive to the compression of premia in risk markets.
It is especially difficult to model how volatility will evolve from here, given the unusual starting point after years of unprecedented amounts of liquidity going into the system; but it is unlikely to be a smooth ride. In the US, some of the liquidity deluge unleashed by the Federal Reserve in the wake of the global financial crisis is being drained out. As this starts to happen elsewhere in the world, volatility (and risk premia) could experience a series of uncomfortable spikes that could affect valuations. Indeed, the second derivative of volatility, that is, the volatility of volatility, has already picked up (see Figure 2), which could imply turbulence ahead.
The May 2013 “Taper Tantrum” is a useful reminder of how prickly markets can be. Back then, all that former Fed chairman Ben Bernanke said was that he planned to reduce the monthly asset purchases of the largest liquidity program of its kind by USD 10 billion, from USD 85 billion to USD 75 billion. This, and a very broad outline of when liquidity might begin to be withdrawn, was enough to rock global markets. It made real rates jump, equity and bond volatility surge and emerging market debt suffer. While economic conditions have improved since 2013 and central banks are normalizing policy gradually, if liquidity is withdrawn globally and growth (also a component of valuation alongside cost of capital) fails to meet expectations or takes time to materialize, then markets could react negatively.
How Investors Might Respond
The appropriate response to higher volatility also depends on the reasons for the increase. If volatility rises on inflation concerns and growth prospects remain uncertain, then over the longer term, we believe investors should de-risk their portfolios and consider risk management or hedging strategies such as tail risk hedges using some combination of options, Treasuries and defensive currencies such as the yen, the US dollar and the Swiss franc. Some of these hedges can be expensive and a robust investment process can help balance the value of the tail risk hedge against the cost. If, on the other hand, the increase in volatility is accompanied by reassurance that global growth will meet or exceed targets, then history tells us that equities should continue to rally and outperform bonds. Moreover, the right sort of increase in volatility could present a more conducive environment for stock-pickers, as stock- and sector-specific factors become more important to valuations and returns.
The right sort of increase in volatility could present a more conducive environment for stock-pickers, as stock- and sector-specific factors become more important to valuations and returns.
Inflation — Cyclical or Structural
A period of sustained liquidity from central banks, such as that we have seen over the last decade, frequently gives rise to concerns that inflation will spike, sparking bouts of volatility until there is clarity on growth, productivity and real rates. So far, however, a key measure of US money supply, M2, has remained well controlled and, as yet, there are no signs of significant wage growth or price shocks. But while our base case for moderate, range-bound inflation remains intact in the near term, it is worth distinguishing between two types of inflation trends. One is longer term and structural and the other is shorter term and cyclical.
Structurally, inflation is likely to be contained over the long term as a result of changing demographics, insufficient productive investment to absorb current labor supply and the disintermediation of technology putting downward pressure on prices and wages. Anecdotal evidence suggests that rapid technological improvements, more knowledge-based and digital assets, mobile working and disruptive business models such as Amazon and Google are suppressing service inflation. While these factors increase productivity, the transmission of productivity gains into output may take time.
From a cyclical standpoint, however, inflation appears to be on an upward trend. On certain measures, including the traditional consumer price inflation (CPI) index, the picture is mixed. In the US, CPI is currently close to the 2% Fed annual inflation target at 2.1%. However, an underlying inflation gauge (UIG) published by the New York Federal Reserve, which attempts to capture price fluctuations through modeling both CPI components and a range of economic and financial data, recently rose to 3% year-on-year, making market participants nervous (Figure 3).
The “prices-only” measure of this gauge, which includes select CPI components, is at 2.2%. The UIG measure can be triangulated by other metrics such as PriceStats, which shows inflation increasing through February. PriceStats gleans millions of real-time prices of popular goods from large online retailers in 22 countries, serving as a leading indicator for inflation before official monthly numbers are available.
Meanwhile, the Fed predicts inflation will rise over the next few months thanks to the year-on-year comparison. Last year’s inflation numbers were suppressed by temporary factors, such as a sharp fall in cellphone prices. No similar changes are anticipated this year, although inflation will likely remain constrained by other factors such as ongoing moderation in rental costs. This year-on-year effect is likely to push core CPI above the Fed’s 2% target in April and May. Even then, the Fed believes inflation expectations will remain anchored, despite expressing concern about the possibility of the US economy overheating. Markets, however, are bracing for an increase in real rates, suggesting they too believe inflation will pick up in the near term.
How Investors Might Respond
In a flexible economy, a certain amount of inflation is helpful in promoting growth. However, price changes must not be too sharp or too sudden or companies and individuals may be unable to absorb the costs. Historically, when inflation has been trending higher but is not excessive, equities have done well while bonds have underperformed. So if there is a cyclical uptick in inflation, it is worth considering maintaining a meaningful allocation to equities, while being mindful that some valuations looked overstretched prior to the recent pullback and growth will need to persist to justify further progress. As such, equities offering value, low volatility and quality should be most in demand.
Higher inflation erodes the value of fixed income, so investors may want to consider de-risking some of their bond holdings no matter whether inflation is cyclical or structural. Bond yields have already risen considerably in percentage terms from where they were last September, so if inflation readings surprise to the downside, we could see bond prices actually rally. If, however, the trend displayed by the PriceStats model continues, then it makes sense to de-risk some bond exposure or use Treasury Inflation-Protected Securities (TIPS) to counter inflation risk.
A balanced portfolio of equities and bonds can offer diversification while both asset classes remain negatively correlated. However, history tells us that when inflation shoots upwards, equities and bonds can become positively correlated and investors lose some of the diversification benefit. As yet the correlation remains benign and negative, but if that changes and growth remains solid, then investors might want to consider increasing their allocation to equities or real assets. Commodities tend to outperform when better-than-expected economic growth leads to a negative supply shock and results in capital appreciation. While past performance is not a guide to the future, historically Real Estate Investment Trusts (REITs) have also benefited from such a backdrop, particularly when they help diversify risk in other parts of the portfolio.
What to Watch
If the global recovery maintains momentum over the next 12 months, investors should expect continued positive economic growth and low unemployment. The flipside of this may well be that long-anticipated inflation pressures finally begin to materialize, volatility rises and markets adjust accordingly. There are three things investors need to watch out for: first, whether growth remains robust; second, whether higher inflation prints across different measures lead to a shift in the structural story of weak inflation; and third, whether higher risk premia in credit markets, measured by investment grade and high yield bond spreads, spill over into other markets. We are in the late stages of the credit and market cycle at which point an increase in risk premia in credit markets becomes a leading indicator of potential turbulence in other markets. It is important for investors to be prepared for when they do.
With contributions from Santosh Prasad, Quantitative Analyst, and Rajni Tyagi, Senior Quantitative Analyst, FICC Research, and Esther Baroudy, Portfolio Manager, Global Equities