The 1970s and Risk of a Second Inflation Wave

Most investors, believe, we are in a benign risk-on macro environment where one should invest along with market momentum (e.g. see the positioning section below). In the last 3 years, narratives for the macro regime went from the ‘roaring 20s’ post-pandemic secular recovery, to imminent recession, to the current goldilocks and best of all worlds when it comes to growth, inflation and monetary easing. Optimism now is quite high and some describe the current regime as ‘parabolic stock markets’ and ‘platinum-locks’ (an even more desirable version of goldilocks). A recent market theory is that stocks should trade higher because r-star (the neutral rate of interest) is making financial conditions easier. This sounds to us like a stretch, and consumers who can’t afford the new mortgage rate or a car loan payment are not deciding based on theoretical changes in r-star. We find current markets developments odd ; for instance the UK, Japan, and Germany being in a technical recession while Europe and Japan stock markets are moving to all-time highs, and various far-fetched applications of AI being fully priced in related stocks and expected to boost to the economy near term.

The increase of CPI and PPI last week and some weaker economic data from the US and abroad cast some shadows on the most optimistic scenarios. With the Nasdaq index rallying ~70% in a year, tight labor markets, and high immigration and government fiscal spending, it wouldn’t be a surprise that inflation may stop declining or move higher. Can one get inflation under control with stock and crypto markets adding trillions of paper wealth, and tightening aspects of QT neutralized by treasury issuance? For instance, just one tech company’s recent gains added the equivalent of the market capitalization of the bottom 100 companies in the S&P 500, and the size of the crypto market doubled since last fall. Can the Fed lower inflation with these developments that are loosening monetary conditions? Historically, loose monetary conditions are a significant driver of upside in CPI readings (Granger Causality Test shows that US Core CPI is driven by Financial Conditions (1-Pvalue) with 99.7% confidence). These inflation considerations are separate from geopolitical considerations such as currently low oil prices (with risk of an upside shock), shipping disruptions in the Middle East, and risk of East Asia supply chain disruptions as a result of geopolitical conflicts or an outcome of US elections. We believe Investors should be open-minded that there is a scenario in which rates need to stay higher for longer, and the Fed may need to tighten financial conditions. The ~25% stock market rally since October was predicated on a repricing of the Fed (from cutting only 2 times in 2024, to cutting ~7 times in January). While most of those incremental cuts are now priced out, the stock market did not correct at all. Volatility has been unusually low, and risk positioning has increased substantially over the past year (see below). Many investors pursue momentum strategies on a cross-asset basis (e.g. heavily overweight equity), or cross-sector momentum themes (such as long mag 7 and short Russell 2000). While momentum strategies most of times make money, reversion points can erase years or performance in short periods of time.

Going back to the question of market macro regime, we believe that there is a risk of the narrative turning back from goldilocks towards something like 1970s stagflation, with significant implications for asset allocation. The 1970s were discussed in the second half of last year, but this scenario was discarded in favor of goldilocks-type outcomes more recently. What were the main market features of the 1970s?  Perhaps the most important is high inflation that came in 3 separate waves ( Figure 1), all in some ways related to geopolitical developments. Geopolitical developments of that era were significant proxy wars in Southeast Asia (Vietnam), several wars and revolutions in the Middle East, oil embargos resulting in energy crises, shipping disruptions, and an increase of deficit spending. Deficit spending and the rise in interest payments (on government, corporate and consumer debt) were a significant drag on the economies in the 1970s. Equity markets were essentially flat from 1967 to 1980 in nominal terms, and bonds and credit outperformed significantly. There are many similarities to the current times. We already had one wave of inflation, and questions started to appear whether a second wave can be avoided if policies and geopolitical developments stay on this course. Similar to the 1970s, there are currently 3 active geopolitical conflict zones – eastern Europe, Middle East, and South China Sea. Related to these conflicts we already saw one wave of an energy crisis, and current shipping disruptions in the Red Sea. By far the largest risk is tensions or a trade war with China that would have a much bigger impact on the global economy and would lead to a significant second wave of inflation and market selloff. Deficits are not on a sustainable path, with the COVID lockdown experimental deficits now in the rear view mirror, but new deficits related to de-globalization (onshoring), the emerging multipolar world, and ongoing wars are likely to contribute to new waves of inflation. This trend may be a reversion of period from the late 1980s to 2000s when the west was enjoying positive feedback loops from the “peace dividend” and is now getting undone into a regime that may be burdened by a “conflict tax or conflict inflation.”

How did this peace dividend feedback loop work? It is essentially a positive feedback loop between improved global geopolitical stability, opening of command economies, and an increase in global trade (goods, services, commodities), resulting in declining inflation and interest rates, thus reinforcing the growth, credit-worthiness and asset valuations across economies. It is easy to see this feedback loop going into reverse, de-coupling of global trade, supply chains and economies that is leading to higher inflation, possible energy and trade disruptions or even hot wars, and growing fiscal deficits, leading to higher interest rates, economic slowdown, and lower asset valuations. If such a negative feedback loop were to take hold (as it did in the 1970s), investors would move out of equities and into fixed income assets – i.e. seek to receive elevated yields that companies and governments need to pay to fund, rather than more elusive equity growth in a stagflationary regime. Equities were flat from 1967-1980, and with yields averaging above 7%, bonds significantly outperformed stocks. In this context, any yield pickup, such as that provided by private credit, would make a huge difference on long-term portfplio performance. A stagflationary environment is also one of higher volatility and higher interest rates, which usually lead to lower liquidity. If one adds volatility that can come from political, geopolitical and regulatory uncertainty, public markets are further disadvantaged vs. private markets that can avoid the limelight of daily volatility. This, in addition to the yield pickup, is perhaps the main reason for the large increase of investor interest in private credit and direct lending over the past year.

Figure 1: Three waves of inflation and equity market performance in the 1970s

Source: J.P. Morgan, Bloomberg Finance L.P.

Figure 2: Inflation-adjusted relative performance of stocks and bonds in the 1970s

Source: J.P. Morgan, Bloomberg Finance L.P.

Elections and Markets

Another macro risk, related to risks for global trade, geopolitical developments and inflation is the US elections this year. Clients are increasingly asking about the implications of elections on markets, and conversely what we can currently read from markets about the elections. This is true in the US and abroad where there are potentially significant implications from the US elections on geopolitical balances and global trade. In 2016, social media analytics were pointing to a likely upset in the election, which we pointed out in our research. Since then,a lot has changed, including the mechanics of elections (e.g. mail ballots), reliability and representation of social media data, and also there is more contention around any discussion of elections. A typical question from clients is whether the elections and certain outcomes are positive or negative for risk, and what is currently priced in the market. There is typically seasonality around the election, where markets are subdued ahead of elections (de-risking due to event uncertainty) followed by a rally once the uncertainty is removed. This effect averaged about 3% performance for equity indices (e.g. 1% underperformance a month ahead of the election, and 2% outperformance a month after the election). While we don’t currently have a view on the immediate market reaction for different outcomes, our view is that there is likely no market upside related to November’s election; the outcome is either status quo (incumbent party stays in power), or increased uncertainty related to global trade and geopolitical or domestic tensions. For this reason, we see US elections as one of several underappreciated geopolitical risks in the second half of this year.

What are the implications of current market and economic conditions on the election outcome? Broadly, the economy does have implications on election, as often attributed to James Carville (see here). But what part of the economy or markets matters the most for elections? Is it stock market performance, GDP, employment, inflation? Figure 3 below summarizes the correlation of various markets and economic indicators in the election year, and the incumbent % vote change in the subsequent election. It turns out that what matters the most for elections is the Sharpe ratio of equity markets as a positive driver for incumbents (and the level of inflation on the negative side). So it is not only important for the incumbent that the market performs well going into election, but that it does so with low volatility/no market turmoil. For instance, this was absent in the two years going into the 2020 elections due to trade-war-induced volatility and the COVID crisis, and it likely hurt Trump’s re-election prospects.

How are the current levels of these variables impacting election outcomes? Over the past year, the Sharpe ratio of the S&P 500 was exceptionally high at 1.8, which is in its ~85^th historical percentile. This is a result of the strong market rally over the past year, as well as low volatility which is in part pressured by increased supply of volatility into the market (via ETFs and short term options). Inflation this year declined, so potentially its damaging impact to the incumbent is lower as well. A sequence of first reducing inflation, followed by a high Sharpe ratio rally would have historically helped the incumbent. If the elections were held today, historical analysis would suggest, all else equal, an incremental ~1-2% incumbent advantage in the popular vote and ~3-5% advantage on the electoral vote due to market and economic developments over the past year. However, one needs to look at this data together with the current probabilities that can be assessed from polling or from betting markets. For instance, if there is 1-2% incumbent advantage due to the market rally and declining inflation, it is likely already priced into the election odds. So, in order for election odds to improve for the incumbent, the market’s Sharpe ratio would need to be even higher, and/or inflation fall even lower, which might be difficult given the extraordinary market performance over the past 3 months and signs of inflation leveling off. The timing of market performance is important, and a year of strong markets might be negative for the incumbent if the momentum is front-loaded and cannot be sustained going into the election.

What is the best place to look for real-time estimates of election outcome probabilities, and how reliable are they? While there is no definitive answer to this question, we provide some thoughts below. There has been much debate over the years on whether betting markets (including PredictIt, Smarkets, Betfair, Bovada) as well as their aggregators Electionbettingodds (volume weighted average Betfair, PredictIt, Smarkets, and Polymarket) or RealClearPolitics (simple average of BetUS, Betsson, Bwin, PredictIt, SportingBet) have historically been more accurate than polls such as YouGov, Rasmussen Reports (and those e.g. collected on the 538 website) in predicting election outcomes. Despite their shortcomings, such as bans in certain countries, fees, potential vulnerability to manipulation, etc., academic research overall finds that prediction markets outperform polls, particularly earlier in the cycle. According to Berg et al. (2008)¹, betting markets are “closer to the eventual outcome 74% of the time” with “the market significantly outperform[ing] the polls” when forecasting “more than 100 days in advance.”. Sethi et al. (2021)²found that in Swing states, markets data outperformed polls-based models from April (start of their analysis) until September 2020. This likely makes prediction markets relevant to investors now and into the summer. According to aggregator Electionbettingodds, over $400 million was bet on the 2020 election, with volumes increasing over the past elections. So far for the 2024 US election, Electionbettingodds has seen betting volume of $50 million, Polymarket $40 million, and Smarkets $3 million; 11 million shares¹ were traded on PredictIt, 3.8 million of which are active. Currently, betting odds slightly favor a Trump presidency (by ~1%), but the picture is complicated with the betting market view that there is a significant chance Biden would not be a candidate (despite no Democratic primaries). For instance, Biden odds on RCP dropped significantly on Feb 9^th, and at the same time the odds increased for other potential Democratic frontrunners such as Michelle Obama (currently at 9.3%), Newsom (7%), Kamala (4%) and others. Election betting odds shows similar trends.

Figure 3: Historical impact of markets/economy in the election year vs. incumbent % vote change

Source: J.P. Morgan, Bloomberg Finance L.P.

Figure 4: Ratio of S&P 500 market cap to US money market assets (left), and US households’ equity allocation as a % of total financial assets (right)

Source: J.P. Morgan, ICI, Federal Reserve, Bloomberg Finance L.P.

Positioning

Investor positioning has increased significantly over the past few months, which may present an increasing headwind for the market. Systematic strategies are running elevated equity leverage, with risk control portfolios’ (e.g. Volatility Targeting, Risk Parity) exposure near post-COVID highs (~90^th %ile) due to the low market volatility, and momentum strategies broadly long equities (outside of China) given the strong price trends (see here). Hedge Funds have also re-levered and are running a near-average equity beta, and net asset manager plus hedge funds’ futures positioning is near record highs. A common refrain from equity bulls is that there is a lot of dry powder that can continue to propel equity markets higher, for example pointing to the large pool of assets sitting in money market funds that could flow into the equity market. However, we note that the asset base of money market funds is historically low relative to the size of the equity market (equity market cap / money market assets ratio is 80^th %ile relative to the past 35Y of history, Figure 4), implied investor cash allocations are below average, and US households’ equity allocations are near record highs ( Figure 4).