Expect volatility bumps in the ‘last mile’ of disinflation road

It’s a narrow path to a ‘Goldilocks’ economic outcome with steep drops on either side. Any easing of inflation is likely to come with real market disruption, which should lead to more opportunity for skilled active managers to show their mettle.

Since 2020, the start of every year has been defined by a single theme. In 2021 it was still about Covid; 2022 saw frantic discussion of inflation and how central banks would get on top of it; 2023 was all worry about them overdoing it. But 2024 starts with “a multi-pronged fork in the road”, according to GSFM market strategist Stephen Miller.

That’s because of threats to the consensus ‘Goldilocks view of a benign slowdown and a smooth disinflationary track, which – if it came to pass – would be very supportive of bonds and equities. Stickier inflation sits on one side of that path, and a deeper recession on the other. But disinflation is a “disjointed process”, and its “last mile” has historically been very difficult to travel.

“Where I have a difficulty with the Goldilocks scenario is the implicit smooth disinflation and deceleration of growth,” Miller said at a recent media briefing. “Given all those risks… we could see episodic bouts of extreme volatility, and that could lead to big shifts in sentiment; big shifts in the prices of financial assets, and for fund managers that could certainly lead to lots of opportunity.”

“The other thing it might underscore is a higher dispersion of individual issuer returns; it’s a great environment for skilled active managers, and higher volatility underscores a message that’s frequently repeated, but a worthwhile one: the importance of diversification.”

That doesn’t mean just via security selection in equities, but looking for sources of return that are uncorrelated with bond and equity beta – long-short managers, macro hedge funds, and selective exposure to commodities like gold.

But there are a number of structural factors that could still become potential inflection points. Regulators are now emboldened to make change rather than sitting on their hands, while the next few years will likely be a period of higher neutral interest rates because of big US budget deficits and the need to spend more on climate change.

“There’s emergent mega forces; climate, cyber security, AI. There’s even the mundane ones like a housing shortage in Australia and how health systems cope with an aging population. There’s all these things out there; some of them are known unknowns, and some of them are unknown unknowns.”

“This occurs at a time when geopolitical risk is elevated. We’ve got a US presidential election; in fact, there’s a whole series of national elections this year. We’ve got the Russia-Ukraine conflict, what’s happening in the Middle-East, China-Taiwan and the Korean Peninsula. I can understand why we’ve arrived at Goldilocks as the consensus view, but I do suspect that it’s insufficiently nuanced.”