Long Story Short: Welcome to the New and More Volatile Inflation Regime

Just a few months ago, US inflation levels hit the highest levels seen since the 1990s. Now the level is higher than at any point in the past 40 years, eclipsing many of our careers in the investment industry. Such a drastic shift in a short space of time requires professional investors to reshape their portfolios in response to the new landscape, but which assets are best suited to high and rising inflation, and which to an environment where inflation has peaked and begins falling again?

Teun Draaisma, portfolio manager at Man Solutions, and his team been developing a robust quantitative investment framework – Fire and Ice – around inflation for the past five years. Recently winning the prestigious Bernstein Fabozzi Jacobs Awards for their co-authored paper The Best Strategies for Inflationary Times, Teun joins Shanta Puchtler to discuss the strategies that work when inflation hits.

Recording date: March 2022

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Shanta Puchtler:

Welcome to Long Story Short. My name is Shanta Puchtler, I'm President at Man Group, and I'll be hosting a podcast series for investment professionals. Every year, we're asked by our clients, investors globally, all kinds of questions from data science, to monetary policy, the effective inflation, how to trade or better risk manage portfolios. It's the goal of this podcast to have wide ranging and deep conversations on some of the most difficult topics that we face today.

Shanta Puchtler:

So in this edition of Long Story Short, we're focusing on the bugbear topic of inflation, a topic that's been on everybody’s mind. We're seeing inflation levels that we haven't seen in decades, and many investment professionals, unless they're on the older side, haven't had direct experience managing portfolios and dealing with investment problems in the face of elevated levels of inflation. So it's a very relevant and timely topic. With me today, I have Teun Draaisma from the Man Solutions Group. Teun runs portfolios specifically designed to incorporate and defend against inflation, and also has written both academic and practitioner papers, analysing and trying to understand inflation. So he's well armed with facts and opinions on the subject. Welcome to Long Story Short, Teun.

Teun Draaisma:

Thank you. Thanks, Shanta.

Shanta Puchtler:

So let's start with a little bit of a level set of sort of where are we in the current inflationary cycle and what do the markets say going forward currently?

Teun Draaisma:

The profile of consensus expectations is very clear across the world in developed markets. Inflation is at a peak in the US and the UK at around 8% in the first half of this year, and then eases back to normal levels by the end of next year. So it's quite a benign consensus view of, after this big inflation spike, things will go back to normal.

Shanta Puchtler:

And when you say normal, do you mean one and a half percent normal or 5% normal?

Teun Draaisma:

2% normal or central bank target normal, is what's widely expected. And that may prove too optimistic in our view.

Shanta Puchtler:

So let's talk about that. You and your colleagues have thought of a lot about this and written a lot about inflation. What's your view of both duration and levels of inflation?

Teun Draaisma:

Our view, our base case, I should say, because it's all about probabilities, of course, always, but our base case is very different from the consensus. And we have two reasons for this, one small reason and one big reason. The small reason is the following, we have a model where we use public information or oil prices and used car prices and asked rents and things like that.

Shanta Puchtler:

Sort of an input model.

Teun Draaisma:

Yes, where we know how that with lack feeds into inflation numbers. And there we get a higher inflation number by year end than the consensus expects. So our forecast for this year is around 6% inflation by year end in the US, for instance, and that's about a percentage point higher than the consensus. So that's a small reason for us to expect higher inflation.

Teun Draaisma:

A much bigger reason is our judgment that the four decade long regime of this inflation has ended. And that judgment is based on a study of history. And we look at history and we find that regimes are very persistent. And then at the end of a regime, you reach the extremes, the logical extremes of that regime. And in this case, that was zero rates, massive debt levels, very large inequality across the world, meaning that the end of a regime, the extremes lead to a policy reaction where everything changes. And the policy reaction is clear, and now it's about fiscal monetary policy, then MMT type policies around the world. That's one key reason. Then there's inflation targeting, of course the central banks have started to adopt. And policy goals such as addressing inequality, addressing climate change. They're all inflationary. The final thing that's also inflationary is repairing or deglobalization, people have now gotten to learn that supply chains are very fragile for a variety of reasons. So all these things are inflationary. So for us, this means that we've entered a longer period of higher and more volatile inflation going forward.

Shanta Puchtler:

Some of the arguments that I've heard and read about are around base effects rolling off, and supply chain repairs, and sort of post COVID it all fixing inflation. How do you incorporate that in your logic?

Teun Draaisma:

I think that's the consensus view. And it's really interesting, it's obvious that the base effects will roll off.

Shanta Puchtler:

Just mathematically.

Teun Draaisma:

Mathematically, for the oil price to keep on having the same impact on inflation, it needs to go up exponentially to have the same year over year price rise. But we strongly believe that's beside the point. Our study of historical inflationary periods shows really convincingly that every inflationary period starts very specifically. It could be war spending. It could be an oil price crisis. It's a very specific start. And then it becomes a generalized inflation.

Shanta Puchtler:

Through contagion? Or through what mechanism?

Teun Draaisma:

Yeah. Mostly wages and inflation expectations. So people get used to this new higher level of inflation and start to demand compensation for it. And as a result, you get into a spiral.

Shanta Puchtler:

A feedback loop, yeah.

Teun Draaisma:

And you don't need strong unions or wage indexation for that to happen. And this time around, of course, we all know labor markets are very tight. There's a shortage of housing and there's been under investment in commodities. But we believe the specific story, partly driven by base effects, is now already moving into a very generalized inflation, which is the pattern we've always seen in past inflations.

Shanta Puchtler:

Got it. I can't help but wonder how the recent events in Ukraine add or subtract from this calculus.

Teun Draaisma:

It's very sad events, of course, but from an economic point of view, it just makes the problem worse. It's stagflationary, higher inflation, lower growth.

Shanta Puchtler:

Explain the lower growth part in your eyes.

Teun Draaisma:

All right. So wars are often inflationary, partly because of deficit funding of war spending, partly because of higher demand for commodities, and partly because of this is supply disruption. And in this case, the supply disruption for commodities is absolutely massive.

Shanta Puchtler:

Primarily around energy and food?

Teun Draaisma:

Energy and food, and then there's neon, aluminium.

Shanta Puchtler:

Small materials, yeah.

Teun Draaisma:

And so it just exacerbates the commodity bull market. And that is not good for growth. It's a tax on companies and on people. So the impact is clearly stagflationary. And also the second round impact is for higher inflation for longer, because central banks at the margin will be a bit dovish, because they'll try to support economies and support markets despite higher inflation. So it's a clear stagflationary impact.

Shanta Puchtler:

So what's a central banker to do? Now they're kind of caught between a rock, a hard place and yet another hard place.

Teun Draaisma:

It's very, very hard. They're in a quandary, because rates are zero, they're still doing QE, and inflation is 8%. How do you normalize rates to tame inflation without creating a lot of damage? What's a central bank to do? Well, they shouldn't start from here, you could say. And it just makes it very, very hard, and it leads to something else. It leads to something else, which is proper inflationary periods last a long time. And they last a long time because the only real cure for inflation is the tough medicine of austerity and very high rates. And early on in an inflationary episode, policy makers aren't ready to do it. They hope it goes away or they think it goes away. And the path to the end of an inflationary period is at first, the inflation itself creates a lot of damage, so much damage that at the end, they'll say, all right, cycle reset, create a recession, and '79, '80, '81 being the extreme example. It's another argument why this period is far from over in our view.

Shanta Puchtler:

So let's shift a little from the level and the expectation to the effect on asset prices. So you've written about that, done some really, I think, quite high quality research around that. Equities, bonds, what's the story in how these assets behave? And then we'll get into some of the more commodity and other assets. But I'm curious, at a high level, what your research looks like, how you did it, and how we can unpick it.

Teun Draaisma:

We did a major study, indeed. It was a challenge because a lot of people have been publishing about what happens in inflations, and they look at data for the last 20 years because, that's what's easily available, and you get to the wrong conclusions completely. So we went back 100 years, we looked at three countries, not just the US, we looked at the US, UK and Japan. We used monthly data for headline inflation and we defined an inflationary period with perfect hindsight. So there's no forecast in there. We just looked at, hey, when did inflation peak at a level above 5%? We identified a major quantitatively as the end of the period, and then the side of the period was the last local trough or the last time you breached through 2%. And thus we found 34 inflationary episodes in the last 100 years in these three countries, that lasted on average just over two years. And because we also have data on 50 strategies and asset classes, we could draw some really strong conclusions.

Teun Draaisma:

So that's the method. Lots of conclusions, but the really short summary is that all these periods may perhaps be quite different, but the pattern is very clear. Equities and bonds do badly and commodities is very, very good. Diversification is key. Take for instance, gold, the go to asset class for a lot of people in inflation. It's pretty good. The average annualized real return of gold in inflations is 13%, plus 13%, sounds great, but the hit rate is only two thirds. So it didn't always outperform. So equities and bones have performed badly during past inflations. Commodities have been much better. The go to asset of choice amongst commodities, of course, in people's minds is gold. And gold indeed has done well during past inflations on average plus 13% annualized real performance, but the hit rate isn't very good. The hit rate has been only two third in these past inflations.

Teun Draaisma:

And what has been much better is a diversified basket of commodities. Plus 15% annualised real return in the past. And a hundred percent hit rate in all inflations that it has generated positive return. And thus, one of the strong conclusions from our study of the past is that diversification is key, as it often is.

Shanta Puchtler:

And what about synthetic assets? Quantitatively constructed assets, hedges, what did you see when you analysed those sorts of assets?

Teun Draaisma:

Yes. So one thing I forgot to say actually, as another general conclusion, that there's no magic solution. It's a beautiful, but very tough conclusion. That is that it's very hard to find an asset class or a strategy that does well in inflations and outside inflations. To your precise question, trends and cross sectional momentum, so trend following in futures and cross sectional momentum to related strategies are very strong, consistently strong. It does take some time for them to morph into what they need to be, logically.

Shanta Puchtler:

To recognize the transition.

Teun Draaisma:

Indeed. And indeed so far, maybe we'll get to that later, but so far in this inflation that started in Feb 2021, trends and cross section of momentum haven't been that good yet. They've been okay, but not as good as the past would've suggested, so their time may come. So that's a standout conclusion in terms of what you call hedges or synthetic strategies. Other strategies that have have been good within equities are the quality style and also high beta, not low beta, but high beta. The big surprise is value. Value, we too believe that there's a good chance that in this inflation, from this starting point, the value style should do well. But historical results don't bear that out. A big surprise. And that's because value changes through time. It's a different beast, if you like, at different points in time.

Shanta Puchtler:

Interesting. And what about inflationary environments did you find, if anything, that relates to cross asset correlation and the correlation structure? Because it's not just what might outperform that we care about, it's sort of how to defend our portfolios through diversification and the benefits of that diversification.

Teun Draaisma:

It's probably one of the most important results of our study. And that is that the correlation structure between traditional assets, it's likely to change. The world, if you look at what the biggest asset allocators in the world are exposed to, they're exposed to equities and bonds by well over 80% on average in our analysis. And that's been the right asset choice, it's been brilliant for the last few decades. They've both gone up at different times, robust portfolio, brilliant returns.

Teun Draaisma:

That's been the norm in the last four decades. It has been far from the norm in the very long history of time when inflation was higher and more volatile. When deflation is the major threat, the correlation between equities and bonds is negative, great, and that's where we have been. When inflation is the major threat, it all changes.

Shanta Puchtler:

I.e. positive?

Teun Draaisma:

Yes. So equities and bonds go up and down at the same time. So you get a much more volatile portfolio. And if history is any guide, they both go down at the same time. The big question is when, from what level of inflation does that occur? And I don't think there's a good theoretical answer to that question, but there's a very strong, empirical answer to that question. And that is two and a half percent headline CPI. If the three year average is the way we cut it, of the headline CPI is above two and a half percent, stocks and bonds are positively correlated and a negative correlation goes away. Where are we now? We're exactly there. We're exactly at two and a half percent, three year moving average. And of course with time, bigger numbers coming in, smaller numbers falling out, we may well be on the cusp of a change in the correlation structure, major challenge to all of us.

Shanta Puchtler:

And I'm just guessing, I don't have the number at the tip of my tongue, but year to date, I think we've seen some breakdown in that historical correlation.

Teun Draaisma:

Completely.

Shanta Puchtler:

From both equities and bonds, depending on how you measure it.

Teun Draaisma:

This is true up to the 11th of Feb of this year, which is when the Russia Ukraine threat became much more imminent. This was this Friday's speech by president Biden. Up to that point, yep, the correlation structure had changed, because inflation and hawkish central banks was the theme. And equities and bonds both went down after that because stagflation has become a bigger threat in the minds of markets. You've seen bonds rally at times and equities go down. So this is -

Shanta Puchtler:

To be determined.

Teun Draaisma:

Exactly. And markets don't move in a straight line. And that's another strong conclusion, when inflation is low, it's not very volatile. When inflation is high, it's also much more volatile, and that creates more micro opportunities and risks.

Shanta Puchtler:

From the history, kind of going back to the beginning of the conversation, you must have been able to collect data on the length of inflationary periods, the severity. Is that all over the map or are there some consistent themes that come out from that analysis?

Teun Draaisma:

Yeah. The consistent theme, there are differences, you can learn from history, and history rhymes, doesn't repeat, all that. Mark Twain, there's always a Mark Twain quote for anything. So periods have been quite different, but the strong theme is that once you enter an inflationary period, it is persistent, and it takes two and a half years on average. And it ends with the recession. So if it's longer, it just means the actual recession, the cycle reset is later.

Shanta Puchtler:

So you get the pain of both the inflation for the two and a half years, and then the recession for one to three or whatever years they're after.

Teun Draaisma:

Yeah. And then off you go. And maybe I give an example or two. So after 1945, there's some parallels, it's quite interesting. After 1945, there was a lot of pent up demand, just like now, post the COVID crisis. A lot of rebuilding had to happen, just like now.

Shanta Puchtler:

Infrastructure spending.

Teun Draaisma:

Exactly. There was financial repression, there was high inflation, but rates were kept low ,so as not to kill the cycle. And it was a very volatile period. And there was a recession every three years because of the impact of inflation, not rates. So high volatility, short cycles and halt cycles. And it looks like we're on that path right now. The even better parallel, I truly believe, is the '60s and the '70s. Most people will tell you, "No, it's completely different now." But I think we're going through it in an accelerated fashion. Late '60s you had guns and butter, the social spending and the war spending that led to a brewing inflationary problem. And in 1973, OPEC crisis, it just cemented the inflation problem for longer. And we've had the guns and butter equivalent, COVID fiscal spending. And sadly, I think the Russia Ukraine crisis can play the role of the OPEC oil price crisis, where it cements. It just accelerates the problem, makes it bigger for longer.

Shanta Puchtler:

So let's maybe wrap up here and ask you to comment a little bit on what would make you change to the positive side, not to the negative side, your views of near term inflationary outcomes?

Teun Draaisma:

Yes. And nothing is certain, and it's all about scenarios and probabilities. We're watching a bunch of things, and let me go through them. One critical thing we're watching is policy. These regimes are driven by the prevailing policy at the time in history. And today, austerity is not the prevailing policy. Austerity is dead. But there's a French presidential election coming up, for instance, and one of the candidates, one of the leading candidates is all about austerity. Maybe she wins, probably not, but if she does, it's a sign. Midterm elections in the US, even more important, perhaps austerity becomes a theme. I wouldn't expect it, but that's one thing we're watching.

Teun Draaisma:

Secondly, we're watching what the market is telling us. Stock bond correlations is the first thing that will move. It's the most convincing thing that will move. If that turns positive like it did earlier this year, that's a clear sign that inflation is the major threat. If it doesn't, we'll have to be nimble and analyse the situation. And then finally, of course, the fundamentals of labour markets. The unemployment rate is at an all-time low in the Eurozone, since the euro was introduced. It's below 4% in the US. Labor markets are tight everywhere. Lack of housing, lack of labor, lack of commodities. We'll just keep on watching that. And that may change, but I don't see that at the moment.

Shanta Puchtler:

Thanks very much for joining us today, Teun.

Teun Draaisma:

It was a pleasure.

Shanta Puchtler:

And stay tuned for further episodes of Long Story Short. Until then, from Man Group, I'm Shanta Puchtler for Long Story Short.