This is the most important tradeoff in the economy. Finding the right balance so that the economy can grow with stable or no inflation is the challenge that policymakers face for the economy and financial system. This tradeoff regulates the natural proclivity for policymakers to increase the money supply to increase nominal growth and gain favor with their constituents. When central banks are able to manage growth and inflation with monetary policy it leads to the classic [[Business Cycle (Short-Term Debt Cycle)|economic cycle]] stages of expansion, peak, contraction, and trough which is driven by [[Credit Cycles]]. When the economy expands and inflation starts to increase the central bank will tighten monetary policy which eventually leads to a peak and contraction as credit is withdrawn from the economy and prices fall until they reach a point where capital returns to the market which leads to a trough and sets off a new cycle of expansion. When monetary policy looses its efficacy it limits the central bank's ability to achieve desired policy outcomes. In the case of an environment characterized by high or rising inflation the central bank will be forced to keep monetary policy tight despite a downturn in growth which could exacerbate an economic contraction. In the case of low or falling inflation the central bank will be forced to pursue easy money policies as the zero-lower-bound for interest rates is reach which could include negative interest rate policies or open market interventions. ## Nominal versus Real We experience the nominal world and we feel the real world. We might get a raise and experience a growth in nominal income but if the prices of the things we consume increase more we are actually worse off. Similarly, you might have nominal friends but if they aren't there for you when you really need them you are still alone despite having "friends". Inflation increases nominal growth but it is a lower quality growth than real growth. [[CHG Macro Model#^78bd8b|Real growth comes from population growth and increases in productivity]]. Given this relationship between growth and inflation we have four different combinations of growth and inflation: | | **High/Increasing Growth** | **Low/Decreasing Growth** | | ----------------------------- | -------------------------- | ------------------------- | | **High/Increasing Inflation** | HGHI | LGHI | | **Low/Decreasing Inflation** | HGLI | LGLI | ### High Inflation | | Stocks | Bonds | Commodities | Real Estate | | ----------- | -------- | -------- | ----------- | ----------- | | Stocks | | | | | | Bonds | Negative | | | | | Commodities | Negative | Negative | | | | Real Estate | Negative | Negative | Positive | | **Stocks Down Bonds Up** In a high/rising inflation regime stocks and bonds are negatively correlated because the central bank acts counter cyclically lowering interest rates as stocks fall and vice versa. Stocks rise and bonds fall during expansions while stocks fall and bonds rise during recessions. **Commodities Up Bonds Down** Because commodities drive inflation and inflation pressures bonds lower there is a negative correlation between commodities and bonds. As demand increases during an expansion commodity prices rise as bonds fall. When demand contracts during a recession commodities fall as bonds rise. ### Low Inflation In a low/falling inflation regime stocks and bonds are positively correlated because the central bank has an asymmetric reaction function where it pre-emptively lowers interests rates to support stock prices and does not raise rates as stocks rise. | | Stocks | Bonds | Commodities | Real Estate | | ----------- | -------- | -------- | ----------- | ----------- | | Stocks | | | | | | Bonds | Positive | | | | | Commodities | Positive | Positive | | | | Real Estate | Positive | Positive | Negative | | **Stocks Up Bonds Up** In a low/falling inflation regime stocks and bonds are positively correlated because the central bank acts asymmetrically to support stocks when inflation is not a threat. Stocks are supported by the central bank during contractions due to preemptive easing of financial conditions . ## High/Increasing Growth, Low/Decreasing Inflation This quadrant has been the primary regime in which modern financial market orthodoxy has been formed. The primary trend that defined this period was the secular bull market in treasuries as pictured below. The peak in yields occurred in 1981 but the bond bull market did not really begin in earnest until the mid-1980s. ![[The Great Bond Bull Market 1981-2020]] Geopolitically this era was characterized by peace, technological innovation, and US dominance. Economically this era was characterized by increasing debt levels, declining inflation, and healthy economic growth. A [[Financial Markets History#Lower taxes, lower interest rates, technology, China 1982-2008|restrictive monetary policy and a capex boom]] led to a downturn in inflation and also during this time China emerged as a low-cost producer after the double-dip recession in the early 1980s. These are just some of the unique features of this period that contributed to the investment returns we experienced. #### Prevailing Market Relationships During HGLI During this period the following relationships are the rule: - Negative Stock-Bond Correlation - Positive Gold-Real Rate Correlation - Yield Curve Inversions tended to precede economic downturns - Growth stocks tend to outperform Value stocks ##### Negative Stock-Bond Correlation The fundamental cause and effect relationship that gives rise to this phenomenon is that lower inflation lowers the cost of capital which increases asset values. The nominal growth rate of the economy is able to stay above the cost of capital without increasing inflation. Stable real growth rates keep a lid on inflation which keeps a lid on nominal interest rates. When real growth accelerates meaningfully above the cost of capital inflation increases and the central bank responds by raising interest rates. When nominal interest rates rise above the inflation rate it lowers asset values and restrains economic growth which eventually leads to lower growth and lower inflation. When equity prices decline due to a recession or decrease in risk appetite bonds are purchased as they offer positive real yields, thanks to declining inflation, and a viewed as a safe haven. Once risk appetite returns, investors return to equities for the higher nominal rate of return. ##### Yield Curve When the central bank raises nominal interest rates above the rate of inflation the market discounts lower growth and inflation and the yield curve inverts. ## Low Growth/High Inflation, High/Increasing Inflation (LGHI) Low nominal growth and negative real growth accompanied by high and rising inflation. A lower currency increases the cost of imports which puts pressure on domestic producers and keeps domestic prices high. Inflation outpaces income growth because business fixed investment growth stagnates and employment falls which lowers the standard of living. The primary goal of the central bank is to reign in inflation but that requires keeping interest rates high. Central banks are constrained from lowering interest rates to address low or negative real growth because of high or rising inflation. Raising interest rates puts further pressure on real growth rates which makes it difficult for the central bank to raise nominal interest rates above the rate of inflation which is required to slow inflation. #### Prevailing Market Relationships during LGHI - Positive Stock-Bond Correlation - Persistently inverted yield curves ##### Positive Stock-Bond Correlation The fundamental cause and effect relationship that gives rise to this phenomenon is that high and rising inflation increases the cost of capital which decreases asset values. Real growth rates are unable to keep up with rising inflation which results in low or negative real growth which pressure asset values lower. Nominal interest rates are pressured higher by inflation while real interest rates remain low. ## High, Rising Growth/High, Rising Inflation (HGHI) High nominal and real growth combined with high and rising inflation. A higher currency invites inflows into the domestic economy keeping prices high. The challenge is keeping domestic incomes high enough to afford rising prices. Competition between domestic and foreign buyers can lead to protectionist measures. The central bank is limited in its ability to lower rates in response cyclical economic downturns due to persistent inflation pressures. Similarly fiscal policy is constrained from counter cyclical actions due to a rising interest burden from rising interest rates. #### Prevailing Market Relationships during HGHI - Persistent yield curve inversion #### Cases - US in the first two decades of the 20th century which also corresponded to the bond bear market from 1899 to 1920. ## Low, Decreasing Growth/Low, Decreasing Inflation Inflation (LGLI) Low nominal growth but higher real growth due to low or negative inflation retards economic incentives by discouraging spending and encouraging excess savings. The central bank's challenge is to raise inflation to change consumer attitudes towards spending versus saving. #### Cases - US bond bull market from 1920 to 1946 which included WWI, The Great Depression, and WWII - Japan from 1990 to present ## Risk Premia The different growth and inflation regimes change risk premia available in the markets. Different asset classes and strategies perform differently in different growth and inflation environments. Inflation erodes the time value of money and therefore we also see a change in how risk is distributed over time across different growth and inflation regimes. **Case Studies** - [[CHG Issue 133 The Macro Blob]] - [[CHG Issue 128 Coherence is the Enemy]] - [[CHG Issue 127 The Importance of Bonds]] - [[CHG Issue 79 The Anecdote is not the Data]] - [[CHG Issue 69 Growth Inflation Trade-Off]] - [[CHG Issue 46 No Longer Transitory]] - [[CHG Issue 41 Second Order Thinking Required]] - [[CHG Issue 33 Goldilocks]] - [[CHG Issue 31 Inflation]] - [[CHG Issue 18]] Explore Further: [[Credit Cycles]] | [[Portfolio Construction]] Tags: #macro-model Your support for Cedars Hill Group is greatly appreciated <form action="https://www.paypal.com/donate" method="post" target="_top"> <input type="hidden" name="hosted_button_id" value="74PGN8ZXHQVHS" /> <input type="image" src="https://www.paypalobjects.com/en_US/i/btn/btn_donate_LG.gif" border="0" name="submit" title="PayPal - The safer, easier way to pay online!" alt="Donate with PayPal button" /> <img alt="" border="0" src="https://www.paypal.com/en_US/i/scr/pixel.gif" width="1" height="1" /> </form>