Macro Report/Insights: Inflation Trades

How does an inflationary impulse impact financial markets and what is the probability of inflation reaccelerating in 2024?

If you work at a large hedge fund, institution, or family office, you have a playbook for every macro regime. The playbook contextualizes the macro environment and the TYPE of trades that are likely to have an asymmetrical payout. For example, PTJ touched on this in an interview a while back:

Part of the value in hiring analysts or consultants is to help build out these types of playbooks so that you have extreme preparation (link):

How to build a playbook:

If you are trying to build a playbook for different macro regimes, there are several things you want to do.

• First, you want to aggregate all the relevant academic literature on the regime and each asset’s performance in the regime.

• Second, you want to have a comprehensive backtest of the regime within the respective country AND other countries. Most people make mistakes because they don’t research their ideas across multiple countries.

• Third, what are the specific trades that have the highest risk-reward and you need to nail during X regime?

There are a number of other things you’d want to have in a playbook but I want to keep it simple here. If you are interested in building out comprehensive playbooks like this, feel free to email me.

Within this context of playbooks, there are two specific papers in my inflationary playbook that I want to cover today:

• Spillover of COVID-19: Impact on the Global Economy

• The Best Strategies for Inflationary Times

The first paper noted the connection between COVID and inflation:

Many people tend to forget that inflation deals with BOTH supply and demand. Interest rates can impact demand but cannot fix supply chain issues. However, if inflation is rising, pressure will be placed on the Fed regardless if its supply or demand. (chart is the supply chain pressure index)

This is one of the things I noted in the bond report:

Paper Alfa

had a great article going over the IMF paper that contextualizes the current inflationary impulse with historical parallels:

Inflation Redux?

When you have an inflationary regime, there is an increase in volatility in the underlying economy. In order to maintain positive returns in a portfolio, volatility needs to be managed or one must benefit from it. This is why alternative strategies and active management carry such a heightened significance. This is likely to continue for the next 5-10 years (at the very least!):

The abstract from the second paper notes the significance of trend-following strategies within this regime which is very important to understand. Here is a chart of the BarclayHedge CTA index and the S&P500:

We can see how allocating to a trend-following strategy can significantly offset losses in passive strategies. If another acceleration in inflation occurs, this will be the default mode for market participants who actively overweight strategies in this manner. It will also provide a significant opportunity for active traders.

Implied volatility remains low right now but this will eventually change. Being prepared with a playbook for multiple scenarios is the key to benefiting during the next shock:

I would encourage you to start reading papers like the ones I noted above so that you know the exact trades to put on when any acceleration in inflation (or recession) becomes the dominant impulse in markets.

Check out the macro report for the exact quantification of these probabilities for 2024: