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Oil price and inflation link is “intuitive, appealing and wrong”
Leading global macro and geopolitical research house BCA has delivered another consensus challenging research piece this week. Writing in a paper titled ‘Solved: The Mystery of the Oil Price and Inflation Expectations’ challenges the current nature and ballooning expectations of inflation.
Drawing on the work of Nobel prize winner Daniel Kahneman, the paper highlights the inherent human bias that means that most investors are “prone to place too much faith in an intuitive answer” that could easily have been rejected with a small investment of effort.
In this case, they are referring to the perceived “tight connection” between the oil price, which has run out of control since the Ukraine crisis began, and inflation expectations. According to the paper, the relationship, which intuitively makes sense, is “appealing and wrong” and significantly so.
One of the key reasons for this assertion is that the predictor of long-term inflation expectations simply isn’t representative of what it seeks to measure. Many professional investors utilise the spread between yields on inflation-linked bonds, or those whose payments increase with consumer prices, and traditional government bonds.
The issue, according to BCA, is that the market for inflation-linked bonds is “tiny”. In fact, in the US the Government bond market is valued at US$25 trillion and the inflation-linked market just US$1.5 trillion. The inflation-linked bond market, they highlight, is driven by a large group of market participants ranging from hedge funds to factor investors and systematic portfolio allocators.
The inflation “scare” that has emerged due to the surging oil price will leave both bonds and equities “vulnerable” they say, with TIPS, or Treasury Inflation-Protected Securities, one of the few assets able to provide a genuine hedge. Clearly, these asset classes dwarf the TIPS market even further, with this “inflation hedging impulse” becoming the dominant force rather than the fundamental purpose of these instruments.
Expanding on this issue, they provide evidence that a higher oil price today, actually more often results in a lower rate of inflation ten years from now. That is primarily due to the higher starting point, with the oil price tending to surge during periods of faster economic growth, and then ultimately representing a peak rather than a trough in inflation. The result is that we tend to “demand inflation protection after it happens and end up overpaying for it”.
This has unique implications for portfolio management as well, given the ‘real yield’ or after inflation bond yield, is a direct input into equity and business valuations. A lower real yield, driven by higher inflation expectations or ‘implied’ inflation naturally suggests equity valuations can also be higher.
From a macroeconomic perspective, the group highlights the risk that the Ukraine triggered supply shock will actually cause ‘demand destruction’ due to the flow on effects of high oil prices. When combined with central banks that are now seeking to “choke” consumer demand through rate hikes and the impending reversal of a “massive displacement of demand into goods” and an alternative approach is required. That is, commodities and TIPS are out, traditional bonds and equities in.
