Volatility: Is Inflation Really the Issue?

Explaining the sell-off

Volatility: Is Inflation Really the Issue?

While some point to inflation fears as the trigger for current volatility, our investment managers question whether those fears may be exaggerated, given economic realities.

Jeff Schulze, ClearBridge Investments

Right now, you’re seeing a tug of war between short-term price momentum and longer-term fundamentals.   We're of the belief that the long term fundamentals will eventually win out. [But] when you have a selloff of this magnitude, bottoming typically is a process, and I would think that we’re probably going to seeing choppiness over the next week or two.  But nonetheless, the path of least resistance is up from here.

In our opinion, it’s not higher rates that’s caused this selloff.  Since September, rates are up about 80 basis points.  But the market was fine for about 65 of those basis points. It’s more complacency, with volatility products exacerbating the selloff.   

Everybody knows that we haven’t had a selloff in quite some time, and if you look at the investor intelligence bull-bear ratio, it was the second highest level ever coming into the selloff, and that goes all the way back to 1987.

So we think investors were over-positioned and obviously with the volatility products exacerbating the selloff, that was a good recipe for the downturn that we've seen.

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John Bellows, Western Asset

What’s interesting today is that with the backup in yields, the market is now pricing in a very optimistic scenario with quite a bit of inflation [and a] fairly aggressive Fed hiking cycle…[with] the Fed able to continue raising rates without any type of pause or hiccup. And most strikingly, it’s now pricing in the possibility of long-term growth and inflation higher than the Fed’s estimate, rather than lower.

We’re cautious on that. We’re certainly optimists in terms of growth over the next few quarters, but in terms of whether the long-term growth and inflation dynamic is shifting, when we look at current yields and pricing we think there’s perhaps a little bit too much optimism priced into the current structure.

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Jack McIntyre, Brandywine Global

We do not buy into this being a start of a big bear market in bonds, because when we look at inflation, we look at cyclical versus secular inflation.  [In terms of cyclical], yes, we are seeing better growth globally, output gaps diminish, markets keying off of the uptick in wages -- so it makes sense that we could see inflation begin to move higher.   

[But] our view is that the lag period from wages actually moving into inflation is going to be longer than what the market anticipates.  I think in some way the long end of the U.S. curve is telling us that because you haven’t seen 30-year yields [surpass] highs from last March.   

And there are things out there [like] globalization, technology in terms of job-killing automation, the competitive backdrop and the amount of debt that’s out there. As yields move higher, the servicing of that debt, the cost associated with that, is going to move significantly higher.  That’s a feedback cycle that’s going to keep a lid on how high yields can go.

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