Thursday, 5 June 2014

Chart of the day - Equity bear markets tend to coincide with high global core inflation

"Once is happenstance. Twice is coincidence. Three times is enemy action." - Ian Fleming

We came across this very interesting chart from Bank of America Merrill Lynch in their recent note from the 4th of June FX Quant Viewpoint "When carry met value":
"High global core inflation as a risk-off signal
Individual country inflation series are noisy, but the average across G10 economies has been stable in the 1-2% range, and has exhibited clear cyclicality. Bear markets for US equities have usually coincided with high global core inflation. We believe inflation based carry will remain attractive until inflation increases globally and we would expect currencies to mean revert when this occurs.

High inflation leads to mean reversion for currencies
Given the strong correlation between FX carry trades and equities in recent years, the observation that recent equity bear markets have coincided with high global inflation suggests that inflation can be used as a carry filter. More generally, we would expect currencies to mean revert during periods of risk-off, which may or may not be negative for carry strategies. Our analysis suggests that a strategy of mean reversion towards 5 year averages would have performed well during the last two periods of high inflation. Is there a fundamental link that makes this robust? 

Inflation matters when inflation is high
Central banks have historically been much more concerned with fighting inflation than deflation, so that high inflation is likely to result in greater attention being paid. Increased attention on fundamentals could drive currencies towards fair value. Behaviourally speaking, high inflation may tip the psychology of the market towards accepting the inevitability of some nominal currency depreciation. This shift in psychology might result in greater reluctance to buy expensive currencies.

Trades for a low inflation environment
The deflationary environment in Japan which began around 1999 coincided with an aging population. The number of people aged 60-64 exceeded the number aged 15-19 as of 2000 (Chart 8). 
There is a natural link between an aging population and low inflation, in that retired people frequently live on fixed incomes so may have constant spending over time. In recent years, central banks have aggressively reacted to deflationary pressure with quantitative easing. Arguably this has been somewhat successful (Chart 9), 
but while US inflation has been ticking higher consistent with our bullish USD view, globally inflation remains low."- source Bank of America Merrill Lynch

Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:
- source

Of course we beg to differ slightly from Bank of America Merrill Lynch renewed bearish view on US Treasuries and rising yields as we are awaiting to see the impact of both Japan's behemoth GPIF re-allocation process in June on spreads as well as what China intends to do when it comes to weakening further its currency, which would in effect have a deflationary impact on the rest of the world

"If you would be a real seeker after truth, it is necessary that at least once in your life you doubt, as far as possible, all things." - Rene Descartes

Stay tuned!

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