Macro: Sandcastle economics
Invest wisely in Q3 2024: Discover SaxoStrats' insights on navigating a stable yet fragile global economy.
Chief Investment Strategist
Summary: Decades of low-level inflation (and even periodic deflation) have conditioned investors against taking it into account when making decisions about their portfolios. Peter Garnry, Saxo's Head of Equity Strategy, presents a descriptive statistical analysis of the effects of inflation on equity returns and explains why you absolutely must consider it a possible factor.
The volatility smile is also visible when we compared equity volatility to the inflation surprise. Again, big surprises in inflation is correlated with higher equity volatility. This link has implications for equity investors in terms of hedging equity volatility. If investors are able to understand changes in inflation over a 1-2 year period equity options are key instruments to hedge equity volatility as equity options do not take changes in inflation into the long-term pricing of these options.
— The introduction of Modern Monetary Theory (MMT) where the fiscal and monetary policies are linked together could cause inflation to accelerate. In the MMT framework a government issuing debt in its own currency only has an inflation constraint to worry about against its spending needs. While this sounds attractive on paper as the government could step up spending significantly, it does rest on the premise that central planners and policymakers understand when the economy hits this inflation constraint. The issue with inflation is that it exhibits convexity and thus becomes highly nonlinear when it’s released.
— The world has a massive infrastructure deficit with the US alone having a deficit of $4.6trn according to the American Society of Civil Engineers. It’s precisely because of this infrastructure deficit and already high taxes in many developed countries that MMT could be introduced as a way for governments to close the infrastructure deficit without the need to increase taxation. As happened during the two periods of World War I and II, this massive increase in public spending would likely propagate through the economy, lifting the price level causing inflation.
— Industry concentration and quasi-monopolies are on the rise and with it extraordinary bargaining power against labour. But with more market power comes also pricing power and this could easily drive prices higher as the deflation engine from globalisation runs out of power.
— De-globalisation drivenby the US-China trade war could also create a sustained rise in the price level as the global supply chain is getting reconfigured. National security issues could cause manufacturing in key industries to be on-shored again. Nationalism could also drive a general trend towards more local production, which in the developed world would arguably drive up prices relative to current levels.