p(stag)

Cam Harvey examines “p(Stag)” — the probability of stagflation — and what a high-inflation, low-growth environment could mean for investors and portfolio construction. Drawing on ongoing research into stagflation and asset management, Cam explains why inflation should not be analyzed in isolation. The economic growth environment matters: an upside inflation surprise during a recession can carry very different information for markets than the same surprise during normal or strong growth. Cam outlines three key ideas from the research: distinguishing stagflation from overheating, using real-time indicators that investors can actually act on, and measuring the acceleration of inflation. He then explores the historical implications for equities, fixed income, the traditional 60/40 portfolio, TIPS, commodities, gold, trend-following strategies, and long-short equity strategies. The episode also considers current inflation risks, Treasury yields, breakeven inflation expectations, and why portfolio risk management can matter even when investors disagree about the exact probability of stagflation.

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Welcome back to Through the Noise. I'm doing it solo this week, and the topic is maybe not what you expect. So in the news is the so-called PDOM, the probability of an existential threat from AI, or X-Risk, which is the risk of the extinction of the human species. I'm going to talk about something a little closer to home and more tangible. And we could call it PSTEG. So what I mean by that is the probability that we go into the dreaded stagflationary environment. So I was recently on stage with Christina Hooper, and we had a conversation at the Mann Alternative Investment Symposium on stagflation. And what I'd like to do is to preview the research that we've been doing that's called stagflation and asset management. So this research is not yet released, but as soon as it's available to the public, I will definitely let you know. So let me pitch the basic idea. So we already know that inflationary periods are bad in general, on average, for asset returns. So our paper does something different. And there are three different ideas in our paper. So the first idea is that the usual analysis just looks at the average. And we know that there could be substantial deviation from the average depending upon the circumstances that we're in. So one key factor in explaining the impact of inflation on asset prices is economic activity. Think of it as GDP growth. So let me give you a simple example. Suppose we're in a recession and demand has collapsed, inflation is very low, and then all of a sudden we see a print for inflation that surprises to the upside. So jump in inflation. So that could be interpreted as good news. So equity returns might actually have a positive response to that news. And the intuition is simple: that the inflation surprise is telling us something about demand. And in the depths of a recession, an increase in demand is good news for asset returns. So now let's consider another scenario, perhaps normal growth or even higher growth. And then we get an inflation surprise. And this could be evidence of overheating, and often it is greeted by markets very negatively. So it's really important in understanding inflation to be able to interact the inflation with the state of growth. So indeed, let me define stagflation. So stagflation is this period where inflation is high and growth is low. The other regime of higher inflation is overheating. So that is when inflation is high and growth is also high. Our paper looks at these two states, these two kind of high inflation states, and then analyzes what happens to asset returns. So that's the number one idea. So number one idea again is not to look at inflation in isolation, but to look at inflation conditioned on the state of growth in the economy. So number two idea. Many people have actually looked at real activity like GDP growth or industrial production growth and made inference about that. So looking at average returns during recessionary periods versus non-recessionary periods. And those recessions are dated by the National Bureau of Economic Research. So the problem with this type of research is that it assumes knowledge of the future. The dating of the peaks and the troughs by the National Bureau of Economic Research does not happen in real time. Indeed, looking at the past four troughs in the business cycle, it took the NBER over one year to decide that the recession was over. So doing analysis based upon these indicators that are not available in real time is maybe academically interesting, but for the average investor or the portfolio manager, it's highly problematic because the information is not available. So the second contribution of our research is to develop real-time indicators of inflation and real activity. So what I mean by real time is that the number is available to you today. And then what we do is to look at the asset returns after we identify the state. So it could be a stagflationary state, which again is high inflation and low growth, or it could be an overheating state, which is high inflation and high growth. So our indicator is investable. And what that means is that you can make a decision based upon our indicator in real time and calibrate that against the evidence that was available in real time. So the third idea in our ongoing research is to look at the acceleration in inflation. So this is uh if you think of inflation, uh, it's the change in a price level. And acceleration is the so-called second derivative. And it turns out that looking at acceleration is really important. So let me preview uh some of the results and then talk about what's happening today. So it turns out, looking at equity returns, that in general uh inflation when it's elevated is bad news. And we knew that. However, the segmentation of the high inflation in terms of stagflation and overheating is very revealing. So, not surprisingly, uh the stagflationary uh equity returns are poor. And the returns in any high inflation state are poor compared to the non-high inflationary state. So this separation is important. The separation between high inflation and low inflation, and again, with our indicator, that is done in real time. So for fixed income, it's not surprising that this is bad news for fixed income. If you think of fixed income just by the very definition of fixed income, the coupon is fixed, the principal is fixed, and if inflation uh goes up, that means that your cash flows are worth less. So again, we diagnose uh the inflation versus the low inflation and stagflation and uh the overheating. We also look at commodities, we look at gold, and we look at inflation-protected assets, as well as other hedging assets such as trend following strategies and long-short equity strategies. So the message in our paper is, and again, this paper will be released soon, that equity and fixed income take a hit in stakeflation, especially, and a 60-40 portfolio is not going to protect you, given that both equity and fixed income are going down. Some of the hedging strategies are very effective. For example, tips, and today the yield on tips, very attractive. So, uh, what about other strategies? Commodities are a mixed bag. However, if you drill down into commodities, something like gold, very attractive. So gold does very well in stagflationary times, and this is because of its perceived safe haven capabilities. The trend strategies tend to do well, so they're protective. And the equity long-short strategies, for example, a quality strategy, is resilient. So you put this all together, and what our paper is indicating, what you should expect, at least from historical experience, in these different episodes. The third contribution about acceleration is really important, and it has to do more with the overheating state. If you're in an overheating state with accelerating inflation, it is devastating for asset returns, for equity and bond asset returns. So this separation is really important. So what do we do with this? So we know that inflation has been elevated, inflation's been over the target of the Fed for 65 consecutive months. And we need to be thinking of these high inflation scenarios, whether stagflation or overheating. And our paper provides some guideposts and some information for pivoting your portfolio to take on some protection. So is it stagflation or overheating? And in a way, it doesn't matter. High inflation is bad news. However, using the information in our research, you can calibrate a portfolio to take these risks into account. And let's be careful here. It is certainly in the news that the 10-year yield is now above 5%. And we should be careful because the break-even inflation on that 10-year yield is 2.33 a percent. And that's approximately what it was a year ago. So, well before the situation in the Middle East. So the market at least is not uh pricing in a large jump in expected inflation. Nevertheless, the market has been wrong many different times. So, what is the probability of stagflation? And we could disagree on this. And for me, I think it's probably about 10%. But some of my colleagues believe it could be closer to 40%. And the message in our research is it doesn't matter. So given that there is a substantial probability, this is the time to pivot your portfolio to take on a more defensive stance against a known risk. We can argue over P stag, but I don't think we should be arguing over basic risk management. So again, I will let you know as soon as the paper drops to the public.