'Painfully Slow Capitulation': Why Investors Keep Getting Inflation Wrong

‘Painfully Slow Capitulation’: Why Investors Keep Getting Inflation Wrong

A brutal third quarter in financial markets ended on Friday and one thing is crystal clear: inflation is the most important factor driving asset valuations right now and yet few, if any, are able to accurately predict where it is likely to go. .

The reason? Professional forecasters, policymakers and traders all continue to dismiss the behavior of inflation in the 1970s, according to BofA Securities global economist Ethan Harris. That’s when inflation – fueled by the Vietnam War of the previous decade – proved relentless, forcing three different Fed chairs to push interest rates above 10% until rampant prize money fever finally broke in the 1980s.

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Friday’s data releases only underscored the resilience of inflation: US stocks ended lower on the day, while posting their third consecutive quarter of declines, after a stronger than expected reading of the personal consumption expenditure price index for the month of August. The Eurozone also recorded a record annual inflation rate of 10% this month. Meanwhile, economists, policymakers, and traders are all factoring in a path for U.S. inflation that falls toward or below 3% in 2023.

The ramifications of underestimating inflation persistence are enormous for financial markets, creating the potential to add further losses to the trillions of dollars of US wealth destruction that has already occurred in 2022. It was the worst September for the Dow Jones Industrial Average and the S&P. 500 of the past decade, and financial markets are on course for their worst year in at least half a century. The usually safe world of global bonds fell into its first bear market in 76 years this month as traders and investors braced for a period of continued rate hikes by central banks.

And the dollar – the undisputed winner of the extreme volatility of 2022 – is at its highest level in 20 years, leading to speculation that intervention is needed.

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Economists, policymakers and investors operate with “a number of potential biases”, according to Harris of BofA Securities.

“The biggest bias has been to ignore the lessons of the 1970s, to assume that the Phillips curve is essentially dead, and to dismiss evidence to the contrary,” he said. The Phillips curve is the economic theory that concludes that lower unemployment is associated with higher inflation. The unemployment rate in the United States has been below 4% for much of the year, which has put pressure on wages, although hopes remain that inflation will eventually come down. “The result has been a painfully slow process of surrender that culminated last month.”

Indeed, the financial markets ended the last trading session of September on a pessimistic note. For the third quarter, Dow industrials DJIA,
-1.71%
fell 2,049.92 points, or 6.7%, while the S&P 500 SPX,
-1.51%
lost 5.3% and the Nasdaq Composite COMP,
-1.51%
fell 4.1%. Meanwhile, on Friday, Treasury yields posted their biggest multi-quarter gains since the 1980s amid a relentless selloff in government debt. And the ICE US Dollar Index DXY,
-0.07%
remained around its highest level since 2002.

The inflationary forces triggered by the COVID-19 pandemic in 2020 have reverberated around the world, and it has been nearly impossible to quantify the ongoing impact. In 2022, it is pandemic-era dynamics that are fundamentally driving inflation – including oversized stimulus that has created increased demand and a “less engaged workforce” who is reconsidering when, how and where she is ready to take jobs, according to Nicholas Colas, co-founder of DataTrek Research.

The main difference between the 1970s and 2022 is that food and energy prices were the main driver of underlying inflation half a century ago, Colas wrote in a note Friday. Severe disruptions in global supplies and increased demand caused food inflation from 1972 and 1973, he said. Meanwhile, energy inflation occurred in two waves: the first being the Saudi oil embargo of 1973 and the second being the supply disruptions caused by the Iranian revolution of 1978-1979.

Right now, labor market conditions “will be more difficult for Fed policy to address,” Colas said.

The Consumer Price Index’s headline annual rate has been above 8% for six straight months from March through August, and traders in derivatives known as fixings are forecasting at least one additional reading of over 8%. 8% for September. Optimism that inflation would soon ease was bolstered by an unexpected downside surprise in July, but faded after the worrying rise in the core inflation rate in August that omitted food prices and Energy.

Fed officials remain hopeful, however. On Friday, Richmond Fed President Thomas Barkin said all signs point to lower US inflation in the months ahead.

But the inflation has baffled even the most sophisticated traders in the financial market, who seem somewhat at a loss as to where inflation will go after the next three months. They see the annual CPI rate hitting 8.1% in August, 7.3% in October and 6.5% or lower in November and December – before falling to around 2% in June.

The reality, however, is that any estimate beyond the next three months should be read as a message that “we don’t know where inflation is going,” said Gang Hu, a trader in hedged Treasury securities. inflation at the New York hedge fund. WinShore Capital Partners.

Hu says he too has been overly optimistic that inflation would show signs of a significant slowdown so far. “We are all used to thinking and modeling in a linear way, and there is no model that can describe what is happening right now.”

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