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    • February 20, 2018
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      Inflation Makes a Comeback

      Yesterday, we saw the signal of our six-month model retract to a more bearish territory. This was caused mainly by the return of our inflation variable. We look at the combination of inflation rates (measured by Consumer Price Index (CPI)) and the breakeven rate (BER). The BER is the difference in yield between government bonds and inflation protected government bonds. CPI inflation measures realized inflation and the BER can be thought of as a forward-looking rate of inflation implied by the financial markets. We also subtract a long term moving average of our inflation variable to obtain a more stationary metric.

      The debate on the relationship between inflation and market returns has been raging for years. Fama and Schwert (1977) found empirical evidence of a statistically significant negative relationship. Fisher’s hypothesis states that stock returns depend on the discounted value of future cash flows and an increase in inflation leads to higher discount rates. However, the lead/lag relationship and timing of this change can go either way. Azar (2010) allows for regime switching and finds that the relationship is significant and negative in one subsample and insignificant in others, but concludes that heteroscedasticity and non-stationarity of the inflation variable could have contributed to these findings. It has also been suggested that inflation becomes more relevant and negatively correlated toward the end of a business cycle (and, likewise, more relevant and positively correlated after a contraction in economic output).

      One of the more convincing narratives surrounding this month’s market tremors has been tied to investors’ expectations about rising inflation and a subsequent increase in nominal interest rates. Therefore, it seems appropriate that our models are paying attention to inflation.

       

      ©2018 Hull Tactical Asset Allocation, LLC (“HTAA”) is a Registered Investment Adviser.

      The information set forth in HTAA’s market commentaries and writings are of a general nature and are provided solely for the use of HTAA, its clients and prospective clients. This information is not intended to be and does not constitute investment advice. These materials reflect the opinion of HTAA on the date of production and are subject to change at any time without notice. Due to various factors, including changing market conditions or tax laws, the content may no longer be reflective of current opinions or positions. Past performance does not guarantee future results. All investments are subject to risks. Where data or information is presented that was prepared by third parties, such information will be cited and any such third-party sources have been deemed to be reliable. However, HTAA does not warrant or independently verify the accuracy of such information. HTAA and any third parties listed or identified herein, including The Journal of Portfolio Management, are separate and unaffiliated, are not responsible for each other’s products, policies or services, and the views expressed are their own.

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