‘Painfully slow capitulation’: Why investors keep getting inflation wrong

A brutal third quarter in financial markets came to a close on Friday and one thing is overwhelmingly clear: Inflation is the single most important factor driving asset valuations right now and yet few, if any, people are able to accurately predict where it’s likely to go.

The reason? Professional forecasters, policy makers and traders all keep dismissing the way inflation behaved in the 1970s, according to BofA Securities global economist Ethan Harris. That’s when inflation — fueled by the war in Vietnam of the previous decade — proved to be unrelenting, forcing three different Fed chairmen to push interest rates above 10% until the fever of rampant price gains finally broke in the 1980s.

Read: Investors may be in for a rude surprise: History shows inflation can take years to return to normal even when the Fed hikes interest rates above 10%

Friday’s data releases only underscored the resiliency of inflation: U.S. stocks finished lower on the day, while posting their third straight quarter of declines, after a hotter-than-expected reading within the personal-consumption expenditures price index for August. The eurozone also reported a record 10% annual inflation rate this month. Meanwhile, economists, policy makers 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’s persistency are huge for financial markets, creating the potential to add further losses on top of the trillions of dollars of destruction in U.S. wealth that’s already occurred in 2022. It was the worst September for the Dow Jones Industrial Average and S&P 500 of the past decade, and financial markets are on track for their worst year in at least a half-century. The ordinarily 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 2022’s extreme volatility — is at 20-year highs, leading to speculation about whether an intervention might be needed.

Read: ‘True carnage’: Stock-market selloff wipes $13 trillion in market cap off broad U.S. benchmark and 2022 has been the worst year for markets (so far) in at least 50 years

Economists, policy makers and investors are operating with “a number of potential biases,” according to Harris at BofA Securities.

“The biggest bias has been to ignore the lessons of the 1970s, assume the Phillips curve is essentially dead and dismiss evidence to the contrary,” he said. The Phillips curve is the economic theory that concludes lower unemployment is associated with higher inflation. The U.S. jobless rate has been below 4% for much of this year, putting pressure on wages, even as hopes remain that inflation will ultimately ease. “The result has been a painfully slow capitulation process that culminated in the past month.”

Indeed, financial markets ended September’s final trading session on a downbeat note. For the third quarter, Dow industrials

fell  2,049.92 points, or 6.7%, while the S&P 500

lost 5.3% and the Nasdaq Composite

dropped 4.1%. Meanwhile on Friday, Treasury yields posted their largest multi-quarter gains since the 1980s amid a relentless selloff of government debt. And the ICE U.S. Dollar Index

remained around its highest level since 2002.

Inflationary forces unleashed by the COVID-19 pandemic in 2020 have reverberated around the world, and it’s been nearly impossible to quantify the continued impact. In 2022, it is pandemic-era dynamics that are fundamentally driving inflation — including outsize stimulus that created a surge in demand and a “less-engaged workforce” that’s reconsidering when, how and where it’s willing to take jobs, according to Nicholas Colas, co-founder of DataTrek Research.

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

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

The headline annual rate of the consumer-price index has been above 8% for six straight months from March to August, and traders of derivatives-like instruments known as fixings foresee at least one more 8%-plus reading for September. Optimism that inflation would soon ease was buttressed by an unexpected downside surprise in July’s reading, but that faded after August’s worrisome rise in the core rate of inflation that omits food and energy prices.

Fed officials remain hopeful, though. On Friday, Richmond Fed President Thomas Barkin said all signs point to lower U.S. inflation in coming months.

But inflation has flummoxed even the financial market’s most sophisticated traders, who appear at somewhat of a loss when it comes to where inflation might go after the next three months. They see the annual CPI rate coming in at 8.1% in August, 7.3% in October and 6.5% or lower for November and December — before falling to around 2% by June.

The reality, though, is that any estimates beyond the next three months should be read as a message that “we don’t know where inflation is heading,” said Gang Hu, a trader of Treasury inflation-protected securities at New York hedge fund WinShore Capital Partners.

Hu says he, too, has been overly optimistic that inflation would show signs of meaningfully easing by now. “We are all used to thinking and modeling linearly, and there’s no model capable of describing what’s happening right now.” 

Source: https://www.marketwatch.com/story/painfully-slow-capitulation-why-investors-keep-getting-inflation-wrong-11664562756?siteid=yhoof2&yptr=yahoo