Unintended Acceleration - How Inflation Could Impact The Markets

Summary

• Market participants seem to have dismissed the recent market rout as being due to short volatility trades unwinding, and inflation concerns have largely dissipated.
• However, investors should not lose sight of the potential implications of inflation returning, as the impact in both equity and fixed-income markets could be far-reaching.
• Rather than being a one-time event, investors should consider the possibility that the market correction was a taste of what could happen if inflation returns faster than we expect.

By John Fujiwara

After stubbornly residing at levels far below its historical average, the Chicago Board of Options Exchange (CBOE) Volatility Index - or VIX Index - spiked at the beginning of February, more than doubling in a single day. Prior to the market correction, stronger-than-expected wage growth signaled to investors that inflation may manifest faster than previously anticipated. After many months of expectations for continued low inflation, this possibility jolted markets. As the VIX skyrocketed, funds trading short positions on volatility (i.e., betting that volatility will remain low) fell precipitously.

The market rout was ultimately blamed on these funds, and inflation concerns seem to have largely dissipated. Indeed, the recent Consumer Price Index (CPI) data beat expectations for both headline and core inflation and subsequently boosted equities.

However, I caution investors to not lose sight of the potential implications of inflation in the market. The impacts of such a scenario could be far-reaching.

Market Reactions

If inflation spikes, the Federal Reserve (Fed) may be forced to tighten more aggressively than expected. This would negatively impact the fixed-income market, as higher interest rates would weigh on the prices of both government bonds and corporate bonds.

However, the fallout would likely not be limited to the fixed-income market. Stock valuations would also be impacted by the Fed's move. Higher interest rates discount future earnings, which translates to lower present valuations. From an economic perspective, rate hikes also feed into investors' fears that the Fed might raise rates too aggressively, in effect slamming the brakes on economic growth and potentially sending the economy into a recession.

Canary in a Coal Mine

Investors should not discount the potentially far-reaching market impact if inflation surprises to the upside. As explained above, a sudden spike in inflation could cause both equity and fixed-income markets to fall. Although stocks and bonds are currently negatively correlated, their correlation has historically been positive. Moreover, as we just saw, an inflation surprise can quickly increase their correlations. Investors should be aware that the actual risk of a 60/40 stock/bond portfolio is likely higher than its perceived risk in this environment.

The question for investors now is whether the market correction at the beginning of February was a one-time event or a canary in a coal mine. Many market participants seem to have dismissed the market moves as being due to the short volatility trades unwinding. However, I caution investors to consider the possibility that it was a taste of what could happen if inflation returns faster than we expect.

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CBOE Volatility Index or VIX Index shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 Index options and is a widely used measure of market risk. The VIX Index methodology is the property of Chicago Board of Options Exchange, which is not affiliated with Janus Henderson.

Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics.

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