In search of a motto for inflation nation

Bottom line up top:

E pluribus inflation. Fed policy, surging oil prices, Russia/Ukraine — these multiple drivers of recent market volatility are closely intertwined with inflation, arguably the most dominant source of investor angst in these turbulent times. Part of what makes inflation so challenging is how difficult it is to forecast. Historically, economists, consumers and markets have tended to get it wrong (Figure 1).?

“When you come to a fork in the road, take it.” Yogi Berra’s famous advice aptly summarizes the dilemma for those attempting to predict the path of inflation. While many scenarios are possible, including “d. none of the above,” here are three currently being debated in the marketplace:

a. Rapid descent. Monetary tightening results in a dramatic near-term slowdown in economic activity, causing the Fed to reverse course.?

b. Not so fast. A more benign outlook. Data will show inflation peaked in March. The rate of increase eases as demand fades, supply shocks begin to recede and base effects turn favorable. Fed tightening is steady but not excessive, clearing the runway for a soft landing.

c. Up, up and away. Probably the worst-case scenario, this path foresees persistently elevated inflation that a behind-the-curve Fed can’t rein in. More, larger and ultimately fruitless rate hikes lead to a much higher “neutral” rate and potentially kill the recovery.

Even the most seasoned investors would be hard pressed to forecast inflation with pinpoint accuracy. But we can use data, experience and judgment to estimate the probability of given scenarios coming to pass — and suggest which asset classes are best-suited to each.

Portfolio implications?

Possibility, not inevitability. We continually debate different potential nearterm scenarios and their likelihood of occurring, and how various investments might perform. Figure 2 shows our framework for these discussions and our current assessments, admittedly a blend of art and science.

Despite recent market angst over yield-curve inversion, we remain confident that a near-term recession is not in the cards, based on several indicators: positive real corporate profits growth, low and falling unemployment, and strong corporate and household balance sheets. These factors inform our expectations of a soft economic landing and still-constructive view on risk assets, while maintaining that the best hedge against near-term uncertainty is portfolio diversification focused on long-term outcomes.

If a near-term recession causes the Fed to reverse its tightening course, we would expect rate-sensitive assets, including longer-duration stocks, to retrace their Q1 losses versus more cyclical counterparts.

In a stagflation scenario, financial assets might struggle as the Fed aggressively hikes to control inflation. As we saw in 1980, a potential silver lining could be an eventual generational buying opportunity for fixed income as nominal yields rise and inflation begins to fade.?

We also acknowledge that while history might rhyme, it rarely repeats, making near-term forecasting a humbling exercise. It’s the “unknown unknowns” — unforeseen events that can’t be priced in — that have delivered the greatest market shocks.?

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