Direction of Inflation

Stress Tests play an important role in improving financial stability by enhancing market discipline and transparency. Clients leverage TS Imagine’s flexible and powerful risk engine to stress test a variety of specific scenarios.

With Americans set to commence voting early next week, markets around the globe are watching carefully. Will the midterms disrupt the Democratic legislative agenda or tip in their favor? We ran two scenarios through our stress-testing engine, gaming the potential market impacts. Please note that these are hypothetical shocks and are not a prediction of any forthcoming events.

“Some say the world will end in fire; Some say in ice. From what I’ve tasted of desire I hold with those who favor fire But if it had to perish twice, I think I know enough of hate to know that for destruction ice Is also great And would suffice” – Robert Frost

In the late ‘90s, two highly regarded colleagues of Morgan Stanley engaged in a debate called “Fire and Ice”, inspired by the poem above. Barton Biggs argued on the side of high deflation (freeze) due to a glut of cheap Asian labor within the world market.  Steve Roach; however, argued on the side of an inflationary bonfire due to public deficits in the West. The current economic climate has brought increasing relevance to Biggs and Roach’s debate.

We have seen inflation rising in response to the global supply chain crisis following COVID, war in Europe, subsequent deglobalization, and an ever-increasing global deficit. The ‘fire’ in this instance relates to Federal Reserve tightening weighing heavy on valuations across all asset classes and Ice being the slowdown in growth, which could be a bigger concern for stocks than inflation or the Fed.

Goldman Sachs expects a 25bp US rate hike in December, following September’s 75bps hike, potentially driving the funds’ rate to 3.75-4% by the end of 2022. It appears that Powell does not want to leave the impression that the Fed will fall short on fighting inflation. That being said, how this changes with a deeper recession looming leaves question marks over policy.

The questions around what may happen with rates and government intervention may also pivot around the outcome of the midterms.  A “historic victory” for the Republican Party in November would pave the way for GOP lawmakers to tackle issues currently plaguing the nation, according to Trump.  There is a likelihood that the Democrats lose at least one chamber; however, political polls and pundits have been wrong before and could be again.

We have generated stress tests, shocking the hypothetical outcomes of the upcoming election:

Stress Outcome 1: Republicans Win Control of Both Houses: Republicans would need to gain four seats to take the House and a 50/50 Senate means they need to net one seat to gain control. Prediction markets recently implied that there is a 74% probability that Republicans could win both chambers, gaining control of the legislative agenda. This outcome could lead to a decrease in spending initiatives over the next two years, alongside a more reactive fiscal policy assuming Republicans could push policies past the White House. We have stress tested this outcome with an “ice” scenario, including continued stagnation. Deflation “ice” factors include:

  • Equities decreasing by 20% (“.SPX” predictive shock)
  • Rates Yields decreasing by 100bps (USD-GOVT” predictive shock)

Stress Outcome 2:  Democrats Retain Control: Polls indicate that Democrats are unlikely to sweep both chambers in 2022, and while there is only a 10% probability of this outcome, any major events leading up to the election could motivate turnout in favor of the Democratic Party.  This outcome could lead to additional fiscal stimulus, potentially funded by tax increases on corporations and those in higher tax brackets.  We have stress tested this outcome with a “Fire” scenario including a refocus toward inflation heating up again. Inflation “Fire” factors include:

  • Equities decreasing by 15% (“.SPX” predictive shock)
  • Rates Yields rising by 150bps (USD-GOVT” predictive shock)

We have not included a stress test outcome of a split control of congress.

This is part 1 of 3 stress test articles we will be looking to release over the coming period.  Materials will be appended to later articles for any readers interested in how these events can translate to shocks in TS Imagine’s Risk platform and the data visualization tools available alongside this.