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Supply-side vs. Core CPI –

Portfolio Construction Implications

US Consumer price data for September will be released on Thursday. Estimates see the headline inflation rising 0.2% M/M, higher than the prior rate of 0.1% in August, while annual CPI is seen paring back to 8.1% Y/Y from last month’s 8.3%. On the core inflation side, the street is estimating a monthly rise of 0.5% M/M with the annual measure also picking up to 6.5%. This week, CPI data will be complemented by the release of PPI and Import Prices, which will give us a broader picture of the recent developments of inflation across the supply chain.

Inflation data will be one of the last pieces of the puzzle FED officials will want to see ahead of the November 2nd FED meeting. The market is now pricing an almost 80% probability of a 75bps hike, according to the CME FED Watch Tool.

Almost a done deal!

But let’s take a step back for a moment, let’s zoom out from the overload of incoming data, and let’s take a closer look at the implications of inflationary shocks from the point of view of more strategic portfolio construction.

Supply-side vs. Core Inflation Shocks

We examined a very simple portfolio, including US Treasuries (2 years and 10+ years), US High Yield, and Russel 1000. We measured asset returns across six buckets:

  • Core Inflation (High, Medium, Low)
  • Energy Inflation – a proxy of supply-side inflation – (High, Medium, and Low)

The analysis spans from mid-80s (except for short-dated treasuries, where the available data sample is shorter) until the most recent data points. The average returns for each of the macro scenarios are plotted below:

Historical evidence, probably in line with economic intuition, shows that core and supply-side inflation carry significantly different asset pricing properties. While a classic supply-side shock has mixed results across asset classes, the real problems for a classic balanced or credit-focused portfolio arise from a core-inflation shock. In this case, in fact, all the asset classes considered have negative returns. We also looked at the conditional correlation between government bonds and equities in various scenarios. What is probably worth noting is that correlations are significantly positive (correlation ca 0.6) when a core inflation shock hits. And positive correlations between rates and credit spreads (equities) are very difficult to deal with because long duration fails to hedge risky assets in risk-off markets. However, when an energy shock is in the making, correlations tend to be more “normal”, and the more classic balanced portfolio starts to function again.

We also looked at the three-months returns of Russell 1000, 10+ Treasuries, and US High Yield in the wake of inflationary shocks. Consistently with the broader scenario analysis we ran above, we can visualize in the chart below that a core inflation shock has a much more adverse impact on the short-term performance of Russell 1000, Long Bonds, and US HY.

Some thoughts on portfolio construction

As far as we are in a world where rising core inflation is the dominant force driving asset returns

We should probably stick to a portfolio built around the strategy that has outperformed so far: Long short-dated TIPS, long US Dollars, and minimal exposure to risky assets.

But, how much is this macro backdrop already priced in?

Looking at the Greed & Fear Index, which is flashing an Extreme Fear signal

And looking at surveys of the most crowded longs and shorts from Vanda Analytics

It looks again that an adverse macro scenario is largely priced, and that markets may be prone to sharp reversals. They just need a catalyst. This could come from below-expectation inflation data, but I would also pay close attention to the developments in the G-20 meetings. Even a rumor of a possible reboot of a Plaza Accord, aiming at weakening the US Dollar, could be a game change

So, if one wants to stick to the winning horse, it is crucial to take into account market sentiment before rushing into momentum trades, remember! Hold your Breath and Count to 10!

What if sticky inflation starts to roll over?

It is probably premature, as no data is confirming yet a change in direction. But pre-planning is always a helpful exercise. Well, in this case, portfolio construction looks completely different.

The building blocks should be long duration, somewhat long risk and short USD.

For fixed-income investors, there are probably two options: either a barbell portfolio of government bonds and high yield, or IG Credit, which is probably a defensive solution.


Personally, I would tend to favour the latter. US IG has been one of the biggest underperformers, since the beginning of the years, and it has one big advantage. It carries significantly lower fat tail risk in terms of corporate defaults compared to a more spicy credit book.


All views expressed on this site are my own and do not represent the opinions of any entity with which I have been, am now, or will be affiliated. I assume no responsibility for any errors or omissions in the content of this site, and there is no guarantee for completeness or accuracy. The content is not meant to be a solicitation to trade or invest. Readers should perform their own investment analysis and research and/or seek the advice of a licensed professional with direct knowledge of the reader’s specific risk profile characteristics.

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