The Inflation Story

This is not another piece about inflation. Well, it is a little, but it is really about stories. Just as most things in investment are. The market narrative of the moment is inflation. The possibility of long dormant consumer prices rising, perhaps substantially, as a recovery from the pandemic (in some parts of the world) meets substantial fiscal and monetary stimulus. The potential implications for interest rates, asset classes and future returns are undoubtedly significant. But what should we do about it?  As investors we lurch from one diverting story to the next, usually forgetting what we were obsessing about in the previous quarter. How do we know how much we should really care?

Financial markets are narrative generating machines. Creating stories is the only way we can deal with the discomfort caused by their complexity and unpredictability. Some can be long-running undercurrents (secular stagnation, for example), others can flare up and come to dominate but only for fleeting periods. The current fascination with inflation is in the latter group, it might morph into something more enduring, but nobody really knows.

We spend most of our time obsessing over these short-term narratives. They spread and bloom with incredible speed. This is both due to their salience (they quickly become incredibly prominent) and their transmissibility – even if you regard an issue as short-term noise, if a client or colleague is aware and asks you a question, you need to respond. A particular story can rapidly become an issue that everyone must address and have an opinion on. It comes to be the focus of every meeting. It is remiss not to mention it. This is where inflation is now. That is not to say it doesn’t matter, but rather because we cannot predict it, we don’t know how much it matters or what to do about it.

Asset prices movements are frequently used as validation for these types of flourishing stories, but that is getting the order in reverse. Often it is the movement in asset prices that creates and fuels the story. Price gyrations must be explained, so a narrative is forged, and its persuasiveness creates increased momentum in prices.  Either a vicious or virtuous circle depending on your positioning.

Most macro investors are playing this momentum / story dynamic (save for a few contrarians). Although they may make bold proclamations about the forthcoming economic environment and its impact on markets, it is typically just momentum trades with a narrative attached. The alternative is to believe that people can accurately predict staggeringly complex systems like economies and markets, but nobody really thinks this, do they?

Inflation is the story today, but there is always something. These often ephemeral, self-reinforcing stories that investors fixate upon have a range of consistent features:

1) Everything is amplified: The implications of a major story are usually greatly exaggerated. We don’t have a mild rise in inflation from unusually low levels, we have an inflation problem. Bonds are not returning to yields of a year ago, it is a rout.  Unfortunately, the power of a narrative is not often related to its credibility or importance.

2) Temporary experts: We will hear most from people whose views have been long aligned with the story that comes into the spotlight. In that moment, they will be considered an expert, even if they have been wrong for the previous decade.

3) Everyone has an angle: People will talk their book on any given story. Don’t ask a bond investor or a commodity investor for their opinions on inflation. We know them already.

4) Stories are often transitory: In the moment, certain stories will feel overwhelming and all-encompassing. What we see is all there is. It is hard to believe that we might well be focusing on something else in a few months’ time. But so often we are.

5) Stories sell: Prominent narratives provide a perfect opportunity to sell products. Stories are how we understand financial markets, they dominate how we feel and behave. Asset managers will inevitably shape their offerings to match the story that – for the moment – has our rapt attention.

Investors are constantly battered by a torrent of stories. These are used to explain or predict market behaviour, from daily price changes to long-term trends and themes. The sheer volume of shifting and often contradictory tales make it impossible to ascertain which are valid and what we might do about them.

Inflation is an important risk that investors must be aware of over the long-run, we should prepare our portfolios for its lasting impact and be appropriately diversified in order that we are reasonably insulated irrespective of the outcome. We should not, however, make rash decisions based on short-term narratives about things we cannot predict.