Market Bets on 1970s Inflation Revival, Despite Fed's Efforts

Market Bets on 1970s Inflation Revival, Despite Fed's Efforts 

After spending the past couple of years rectifying his significant error from 2020/21, during which Powell flooded the market with excessive liquidity, triggering the second most significant inflation surge in modern US history (only overshadowed by the almost hyperinflation of the Volcker era), the Federal Reserve chair has been working frantically to salvage his reputation and legacy. He's achieved this by raising interest rates to levels not seen in four decades, aiming to control inflation and avoid a repeat of the 1970s "Arthur Burns" Fed blunder. Back then, premature easing led to a second, more severe wave of inflation, climaxing with interest rates soaring as high as 15%.

Regrettably for Powell, the markets seem to believe he's already lost the fight against inflation, and potentially the entire battle.

Goldman Sachs recently introduced a new basket, called the GS1970 Inflation Comeback basket (GSXU1970), which essentially rewards stocks expected to benefit from a resurgence of 1970s-style inflationary pressures. This indicates that the market anticipates a second, even more perilous wave of inflation is on the horizon.

Louis Miller from Goldman Sachs explains that the GSXU1970 basket consists of industries that historically outperformed the market during the inflation surge of the late 1970s, including oil, mining, fabricated products, transportation, construction, and real estate. Despite the current decline in inflation, the conditions are favorable for these inflation-oriented stocks. Their disciplined management teams, focused on shareholder value, along with strong valuations, balance sheets, and return of capital, provide a solid foundation while awaiting a potential uptick in inflation or global growth. Additionally, these companies tend to perform well during periods of underperformance in other sectors and geopolitical tensions.

Recent trends suggest that the market is favoring pro-cyclical investments, driven by high nominal growth and inflation rates, which benefit commodities and high-return cyclicals. Stocks in sectors like oil and mining are rebounding, as are those in the high free cash flow basket, indicating a readiness to capitalize on inflation or global growth upticks.

In contrast to the views of Goldman's research desk, which predicts a collapse in inflation by the end of 2024, the trading desk favors the GSXU1970 basket to capitalize on the continuation of inflationary trends. This contradiction might not sit well with Jan Hatzius and his research team, knowing that their trading counterparts are taking an opposing stance.